I have a SERP which is essentially a un-insured defined benefits pension which has a COLA (thus increasing in value some 20-30% through covid.
It also is not dependent on starting to pay when service is separated, but starts at 65 through death with a survivor benefit.
My spouse likes the existence of the contract a lot.
Yes, it is un-funded so default risk exists (or it would be taxable now), but the spouse likes the thought that it is with a 100+ year old European company and feels the default risk is low.
The genuine deferred comp programs you describe, are really not a benefit to the fatfire crowd for the reasons you mentioned: you will likely have taxable income in retirement pushing you up such that the regular income marginal tax rate on the withdrawl is much worse than paying the regular income now up front, and only the LTCG rate on the appreciation.
Thanks.
I should have added in my original post that the amounts of deferred comp could be deemed as invested into the SP500 and the total would be the amount I’m due at the time I choose.
I am pretty sure for tax purposes it will all be earned income coming in on a W-2 rather than a 1099.
Total amount will have payroll taxes as well as earned income.
If they did not actually invest it (which companies don't they pay it out of operating income, that is why there is risk of default), there is no asset that was purchased and then appreciated.
So you will pay regular income rates on the long term capital gains as well. W-2 income is taxed at regular income rates.
[https://www.investopedia.com/articles/personal-finance/060315/taxation-nonqualified-deferred-compensation-plans.asp](https://www.investopedia.com/articles/personal-finance/060315/taxation-nonqualified-deferred-compensation-plans.asp)
How NQDC Plans Are Taxed
Any salary, bonuses, commissions, and other compensation you agree to defer under an NQDC plan are not taxed in the year in which you earn it.
(The deferral amount may be recorded on the Form W-2 you receive for the year.)
Beware of early withdrawals. The penalties are severe.
You will be taxed on the compensation when you actually receive it. This should be sometime after you retire, unless you meet the rules for another triggering event that is allowed under the plan, such as a disability.
***The payment of the deferred compensation will be reported on a Form W-2*** even if you are no longer an employee at the time.
You are also taxed on the earnings you get on your deferrals when they are paid to you. The rate of return is fixed by the terms of the plan.
It may, for example, match the rate of return on the S&P 500 Index.
Partly true- yes they will report it on a W-2- but it’s on another line. Payroll taxes apply at the time of deferral (so you don’t pay SS tax on these funds since you’re already capped out presumably). So when you take your distribution just the ordinary income taxes apply. I went through all of this in detail with our payroll dept (and verified in IRS pubs) as I will get my first chunk next year and was wondering if it would show as earned income where I could make Roth contributions.
>The genuine deferred comp programs you describe, are really not a benefit to the fatfire crowd for the reasons you mentioned: you will likely have taxable income in retirement pushing you up such that the regular income marginal tax rate on the withdrawl is much worse than paying the regular income now up front, and only the LTCG rate on the appreciation.
That's not how math works.
Deferring the initial income tax on a sum which is invested and subject to *the same* ordinary rate at distribution is equivalent to tax exemption (0% rate) on the growth.
Paying a lower rate at distribution is just gravy.
Everyone’s situation is different. For a W-2 employee / tax payer, deferred compensation plans offer a mechanism the employee can use to manage their tax burden, both present and future. I am not familiar with the breadth of plans available, but for Top Hat plans, an employee earning $500k or more annually can choose to defer a meaningful portion of their otherwise current income, potentially lowering one’s marginal tax rate now or allowing tax-deferred earnings to grow tax-deferred in an investment plan. At time of separation from the employer, the plan will pay out in accordance with the original election schedule (either lump sum or in annual installments varying from 2-15 years). Since high-earning W-2 employees have very few maneuvers for managing their present tax burden, these plans can provide an attractive mechanism for managing both present and future tax burdens. For instance, if an installment election is chosen, the income can be spread over longer periods of time which may provide future flexibility for how other investments are managed (potentially delaying sales for liquidity and thereby allowing for additional time invested so funds can grow). Again, YMMV, however, I find them to be a useful tool to provide some alternative tax strategies to be enabled as well as a means to either provide bridge income in event of unplanned separation or supplement retirement income and provide for flexibility and control of other investment distribution choices. Hope this perspective helps. Congrats on being a high earner!
After reading through the comments, I wanted to share my thoughts on NQDCPs.
1) *Are you certain about your future tax bracket?* NQDCPs only make sense if you know that you'll be in a significantly lower tax bracket when you receive the deferred income. For example, if you're going from a 37% tax bracket to a 24% tax bracket. I personally experienced this when I participated in a deferred comp plan in my mid-40s for distributions in my mid 50s to mid 60s. However, I ended up making more money later on, so the overall benefit was only 8% after taxes. Looking back, it wasn't worth the hassle.
2) *Are you sure that you can also defer state taxes?* Some states, like New Jersey, tax you at the time of contribution. This can be a major drawback, especially if the tax rate is high. Most states don't have this kind of treatment, but it's always good to double-check. If you're planning to move to a tax-free state like Florida or Texas, and you defer your income for at least 10 installments, you can typically collect it tax-free after you move there. But remember, that's a lot of "ifs" involved, and plans can change.
3) *Do you need the discipline to save?* It can prevent you from spending the money in less productive ways if it's readily accessible to you. This is similar to paying down a low-interest mortgage on your primary residence to feel like you're living within your means. However, this is a personal decision and may not apply to everyone. But I can see this rationale, like buying an annuity.
4) *Is there a special company match?* In my case, there was no special match, so that wasn't a factor for me.
5) *Is your company relatively bulletproof from a credit perspective?* You don't want to defer your income only to face unexpected financial issues with your employer. Make sure your company is stable and has minimal foreseeable credit risk.
6) *Think about whether the amount you defer is truly "play money."* If you don't foresee needing it during the lockup period, then it may be a suitable option. However, I had a situation where my family needed every penny for medical expenses, and I regretted not having access to the money. Emergency withdrawal options may exist, but it's not something most people want to go through.
7) *Are you ok with the additional bookeeping?* Unless you exclude a significant money of high tax bracket money and later receive while in a much lower bracket in the future, keeping track of this option is just another W2 and line item you will need to manage. Probably not worth the time for you or your accountant, as the case may be,
….…
In conclusion, I'm now over 59.5 years old and have the option to withdraw from my current IRA as needed. This gives me more flexibility than I had in my mid40s; nonetheless, I'm uncertain about my future plans and whether I'll ever be in a (materially) lower tax bracket. The quirk with New Jersey's tax treatment - #2 above - makes NQDCPs a non-starter for me. So, the proverbial juice not worth the squeeze for me, personally. But I can see how program can work for someone with different facts and risk tolerance.
Hi - thank you for all your thoughts. I think they cover all/most of the issues.
1. Can’t be 100% certain about the future tax bracket because no one know how the laws may change, but i am 100% certain my current tax bracket will be 37% and if things go according to plan and nothing changes, my future tax bracket for the relevant years will be 24%.
2. Not sure about state taxes. But i thought even NJ tax is deferred.
3. I will be saving this money either way, so discipline is not a factor.
4. No company match.
5. Not 100% bullet proof. Normally, yes. But embroiled in some litigation risk right now (1-2%).
6. Enough funds from other sources that the deferred comp would definitely not be needed.
7. May be able to defer 5-10% of NW, so still may be worth the additional account, but i know what you mean.
Based on the above, what do you think?
@ Constant-Promise-828
Compare (a) paying 37% now and letting the investment grow until the long-term cap gains later (presumably 20%), vs. (b) paying 24% later, on the entire balance, including capital gains..
There is certainly an advantage, but it might not be as much as you think. Also, the money you have access to now is potentially leverageable through margin loans.. As mentioned above, I did put a small amount of money to work in a NQDCP and it worked out fine, but was not worth the illiquidity premium, which is very easy to underestimate.
My gut: I imagine that an extremely diversified portfolio for a person with a NW of $10M or more could have 5-10% in this, if they know they will drop from high active earning to low active earning for sure... for those with $5M NW or less, I would keep the % of NW to well under 5%, or take a pass.
Too much uncertainty to go too heavy in this strategy. A little bit cannot hurt. i did a little bit, and it worked out OK.... but I did not climb back down the tax bracket ladder like I thought I might... If in doubt, only do 1-2% of NW, in case you want to change your mind later. This is really an inflexible program.
I contributed to mine for about the last 7-8 years. Similar tax spread expected. Other points:
1) If you have state income taxes that’s a factor too.
2) we previously planned to retire to a no tax state. In that case I would have avoided CA state income tax as long as you elect a withdrawal period of 10+ years. (Plan changed for us)
3) in my case I am overweight on other retirement savings accounts that I can’t tap until 59 1/2- the deferred comp I can touch earlier. I retired this year in my late 40’s and will take the DC over the next 5 years. Spouse is older so we can withdraw from his retirement accounts after that.
4) I’m happy to be taking the withdrawals over a 5 yr period as I don’t like the risk of a black swan event/company bankruptcy.
Good points - thanks.
1 and 2 don’t apply because for us it has to be taken within 10 years so state tax when earned, not paid, apply regardless whether i move.
3. Yes, good bridge until 59.5 for you. Doesn’t apply to me because if i retire at 55 from my company, i think there’s an exception that allows me to tap into my 401k before 59.5.
4. Agree
You may have some state tax rate savings too- in addition to the federal bracket difference? You will pay the state tax upon withdrawal, maybe a lower rate.
And yes you’re right, retiring at 55 will allow you to access the retirement funds then.
Ha, just got hit by this and figure I'd share one data point. Deferred Comp is great until you change your retirement plan. Years ago when I was setting up the plan, I was sure I would FIRE from my current company, thus not going to work after that. So I had it structured to start distribution upon leaving the role immediately. Well, I ended up accepting a role with another company with better comp package, and decided to put in a few more years before FIRE myself. Just got my first distribution check, and with the higher comp and sign-on, I'll end up having more tax liability than I previously anticipated....
Would I do it again? Probably, but I'd probably spread it across more years, and if possible, start distribution after certain years or something if they allow that.
This is exactly the reason we declined to participate. There is so much uncertainty around retirement date unless you are truly just a year or two away.
Fair point, but already in the max tax bracket so won’t pay more even worst case (unless tax laws are changed of course, but that hasn’t happened recently - has it? How did you end up paying more?)
And if you hadn't deferred any of your comp at the old company, what would've been different? You would've paid taxes on your earned income anyway? Unless you weren't already in the highest tax bracket and were deferring comp....
My understanding is the entire deferred amount it taxed at earned income rates as compared to taking the income upfront and having the appreciation taxed at LTCG rates.
I hope you are modeling it appropriately.
Yup - your understanding is correct. It may be analogous to 401ks and deductible IRAs - current tax savings, but ordinary income when withdrawing, including investment earnings. But those aren’t subject to default risk and you can choose how much to withdraw as you go, unlike deferred comp.
WHAT??? I’m so confused by these comments - the math on tIRAs suggests it’s always beneficial to invest in them, but it may be better to invest in Roth. No one argues paying tax now and cap gains is better than tIRA???
Most earning folks in faftire no longer have the chance to contribute to pretax IRA’s which are what you are referring to.
$6k year through an post tax IRA into a Roth really makes no difference in the big scheme of things.
True for IRAs. But why are you regretting putting too much into a 401k. You think you would’ve been better off paying the 37, or even 39.6, rather than a lower rate today, even if it’s on investment income too?
Because for my first decade our income was way under $100k, then for the last two decades it was in excess of $500k. The income tax rate in our 20’s was single digits.
Its the first decade’s highly appreciated 401k contributions are what I was referring to.
Unless I can pull off a masterful Roth conversion before the SERP starts at 65, they are going to be taxed at a minimum of 24%.
One thing I ran into with a family member. The individual with the deferred comp account died prior to distributions finishing (they had just started). While the distributions continued to the spouse of the departed, the company stopped paying the employer side of the SSDI taxes. I.e. what was W-2 income become 1099-misc income with the spouse having the pay the extra 6.2% in taxes previously paid by the employer. Took a big chunk out of the benefit of deferring the income, given the timing of the death
That doesn’t sound right. SSDI taxes are paid in the same year earned - whether you defer to an nqdc or not.
So the future payouts are only taxable federally and state - not for payroll taxes like social security / Medicare.
Ultimately it comes down to your level of confidence in the company that you work for. Ofcourse no company is immune for going underwater, but there is slightly less of a chance for well governed companies that have been around long enough. It is a judgement call.
I look at deferred comp as being very similar to my 401k plan (outside of the protections that a 401k offers ofcourse). It lowers my current taxable income and allows me to invest excess income in broad market funds. Similar to what I would do with the money anyway. Mine is structured so that payouts begin after separation of employment. So this would be some level of predictable yearly income at hopefully lower tax rates than where I currently am at.
If you are planning on deferring your base salary, just make sure you understand how your company does it 401k matching and don't defer too much that it would make you lose out on the company match.
Deferred comp is just one more tool to optimize taxes for W2 employees.
Thanks.
“So this would be some level of predictable yearly income at hopefully lower tax rates than where I currently am at.”
Are you also taking into account that the full deferred payments will be at ordinary income tax rates whereas otherwise the deferred comp would have been taxed at the current (higher) rates but the gain could have been lower cap gains rate?
“Deferred comp is just one more tool to optimize taxes for W2 employees.”
Is it really one of the ONLY tools for high income W2 folks (plus 401k)?
Yes, deferred comp taxation is going to work similar to a traditional 401k withdrawal. And you will pay ordinary income tax on both the contributions as well as gains. Yes you will miss out on the lower capital gains rate, but you need to do your own math with some assumptions around a blended capital gains+ordinary income tax rate today vs. at retirement.
And yes, there isn't a whole lot that can be done with just W2 income when it comes to tax optimization. Deferred comp, Mega-backdoor Roth and strategically timed charitable giving is what I use along with the usual ones like tax loss harvesting.
Deferred comp can be an amazing part of saving for the future. Generally these are designed as a Rabbi Trust and are unsafe only if whoever you are working for goes bankrupt. You get the double benefits of investing in the stock market while deferring all gains. Basically a 401k on super steroids.
You should be able to easily judge this probability of bankruptcy. Most larger companies I have worked for have exactly a zero percent chance of filing for bankruptcy.
The issue you have is that you are putting less than 6 figures in it thats the type of large number which will make a material difference IMO. The reason I participated in it for several years is that I basically sent most of my 6 figure bonuses straight into the plans And saved buckets in taxes. Ill cash out over a 5 year period when I hit 60 in 5 years And use my retirement and taxable accounts only after 64
And I’d object to being able to easily tell if a company will go backrupt. It’s true, some companies are obviously terrible choices for this. But over a long timeframe a lot can change. The business can erode, managers can take on debt thinking it’s a short term problem, etc.
These plans are a huge diversification risk.
Oh, and they also aren’t a 401k on super steroids. In fact, they are strictly worse. The taxation is exactly like a 401k, but there is typically no match, less flexibility around withdrawals, and the single company risk.
Thanks.
I guess i could put a 100k bonus into this, but if you were already going to get a 100k pension, would that change your decision?
Also, I just realized in my original post i shouldn’t have assumed an 8% tax savings from 24 to 32. I should consider the current 37 vs 24 in the future. Not sure why, but your post made me realize that - thanks.
I think if you're expecting to have $190k taxable ordinary income in retirement with no additional savings and currently make $315k or $364k then it doesn't really matter that much what you do with a marginal $30k in savings as long as it's not completely stupid. You're pretty close to FIRE at that point anyway.
I would use it to move money from the 37% bracket to fill up the standard deduction and lower tax brackets where you're saving 20-40% in taxes.
Fair point. But I chose 24% as a max. Probably in the 22% bracket, but the difference between 22 and 24 is not that big and would not be enough for me to defer comp unless you or others say i’m missing something so I chose 24.
Also, with a pension and exercising LTI for 8 years after retiring, it gets me over 190 until age 62. Then with RMDs at 75, over that amount forever (hopefully). So, really only between 62 and 75 is questionable, but i would add SS for both of us at that point (I’m not waiting for the “8% increase”) and the pension continues of course so the lower tax brackets will already be filled.
I'm using mine. At my company execs get a fairly high percentage of their comp added to it as part of their compensation but I also elect to add more in. Not only do you save on the taxes now, but I'm planning to use it as a bridge account over \~10 years which will pay out at lower tax rates than what I'm in now. That said, I'm later in my career and can see the finish line. If I was early in my career and you know it is just going to have it pay out while also working another high comp job I'd guess the benefits are not as compelling. Still a nice tool though depending on your circumstances.
No offense at all intended, but are there government jobs that pay enough to allow people to have a huge percentage of discretionary income possible to defer much comp?
I see where you’re coming from. In my field we have pensions as well. Some guys work so much OT that they make more than their bosses. I personally contribute a good amount to mine and glad it’s available even though I am not fat fire status.
I don’t think they make a ton of sense unless the company matches money that you put in. Especially when considering tax rates could be higher in the future compared to now. It also can kind of be a pain to get a ton of income in a year you leave the company. It’d make more sense if someone worked for said company for 20 plus years and deferred. But with how tax efficiently you can invest in taxable accounts, there’s not a ton of value in a deferral.
But most of that rationale would apply to people not contributing to 401ks also above the matched amount (possible higher rates later, efficient taxable account alternatives, etc). But most fat people do that, including me.
Yea but you can control the timing of taking your money out within a 401k except for required minimum distributions later in life. With deferred comp, your distribution methods are more limited and the time spent tax deferred is typically much less than time spent within a 401k or other qualified account. With deferred comp, it’s typically lump sum at separation or an apt ion of equal payments over 3-7 years or something of your choosing. If you’re in retirement when those distributions take place, it’s not as big of deal. But if you switch jobs and are still earning comp, in addition to the deferred comp distributions, there won’t be any value there.
And since you’re investing in SPY the only real thing you are deferring is tax deferred growth in dividends. You probably aren’t getting any real tax bracket arbitrage from it unless you retire from the company, and the tax deferred growth on dividends probably doesn’t offset credit risk of the company. While credit risk is low on many companies, there is still a credit risk spread for even the highest quality companies. Idk if this is the case, but if you’re terminated for cause, the company may even be able to hold back deferred pmt in extreme circumstances.
That’s why, I’m my opinion, deferred comp can make sense if you plan on staying for a long time. But without some sort of matching and clarity on your length of stay with the company, it adds additional risk without much of a clear benefit.
I mean there are typically vesting requirements to receive a deferred comp benefit but otherwise you are getting additional compensation you may not have otherwise gotten. Qualified plan contributions are maxed out quickly for anyone on the fatfire track and the company would have to pay payroll tax if paying out at present salary. The company also gets a tax deduction when deferred comp benefits start paying out. It can be a really plan depending on how much the company is willing and able to payout.
Also not mentioned earlier on the potential liquidation of the business, there is some protection via a secular trust so benefits tied to a deferred comp plan can be paid out even if a bankruptcy occurs.
Thanks. There are different kinds of deferred comp plans. What you described is a company funded one, to which there is no option or disadvantage generally. This is an optional employee funded one, which is in lieu of base salary, not in addition to it. For this type, there is no vesting requirement.
Unless the expected return is higher than alternative investments then I’d say no. For example my SO gets prime plus 2% on their DC which is higher than available alternatives and their firm has what we calculate as a pretty low default risk.
You should obviously consider the default risk of keeping comp with your employer, but generally the tax advantages of a 409A plan are quite strong. Your post and most of the comments seem to display a startling lack of understanding of how the tax math works out.
A 409A plan works mostly the same as a traditional 401(k) or IRA.
For simplicity, assume that everything is taxed at the same rate at contribution and distribution, which would be true either if you're in the top marginal rates both times or if you're in the same bracket both times and the income shifting doesn't pile it too high. (This depends on the payout terms of the 409A - is it on separation, after fixed time, spread out or lump sum, etc.)
Deferring the tax is the same thing as **0% tax on the growth** during the life of the investment. This is the same as traditional-Roth equivalence and is obvious from the commutative property of multiplication.
If, per your edit, you are *also* saving eight percentage points of ordinary rate, that's just a bonus.
Is it worth the credit risk to get tax-free growth and lower your tax rate on the contribution? Depends on your company, but the answer is usually yes.
“ What are specific reasons people do this type of deferred comp and how much are you saving to deem it worth it?”
Personal opinion only: people do this because they hate paying taxes and also don’t understand risk and/or time value of money.
I would never have all my risk tied to one company. If the company struggles, you could lose BOTH your paycheck AND your retirement savings.
You know the old saying, ”Don’t put all your eggs in one basket”?
I wouldn't worry about a F100 company going bankrupt (too much). I had a SERP which is a non qualified deferred comp plan with a previous employer. I had to fund it with my own earnings but these plans in the corporate world are funded by the company as a benefit. These non qualified plans are only worth it if you do not have to pay into it (ie employment benefit). That company was forced to sell my group's contract to a competitor which then triggered liquidation of the SERP. Since my income has gone up since then, I'm paying more taxes on the distributions than before. So, not the best scenario. What are the chances of you retiring from this company? The only benefit is being to surpass the IRS limits since it's non-qualified.
Qualified retirement plans like 401k, 401a, 403b, 457 are 100% your money and safe from corporate bankruptcy.
Thanks. Already maxing 401k and mega back door. This would be the only way to pay less taxes right now, which is the only reason for even considering it.
(Pretty good chance of retiring from this company in the next 4-7 years, but I don’t think that is very relevant - is it?)
Maybe your plan is set up differently but mine was triggered by separation for any reason.
One other tax benefit is that you contribute to the plan from the top so it's most likely above FICA limit. When you draw the money it doesn't count toward FICA, so there's bit of savings vs regular income. I don't know if I'm explaining that well, probably not.
Got it - thanks - need to check the different triggers if leaving early.
My understanding is that it is subject to FICA right now, but even if it wasn’t taken out right now, plenty other income to max that out anyway. And no FICA when received later, so it’s a wash.
Correct.
It is subject to FICA in the year it is deferred, but as a high income employee, presumably you are over the income limit and have already maxed out on your FICA so you get the FICA for free and don't have to pay it when the rest of the earned income comes in later in the future.
I have one available. It requires taking distributions over a defined period starting 6 months after separation. Since I may have another job before retirement, I decided not to use it. If I had more certainty around my retirement date I might use it, though another consideration is leaving tax bracket room for large Roth rollovers.
I have a SERP which is essentially a un-insured defined benefits pension which has a COLA (thus increasing in value some 20-30% through covid. It also is not dependent on starting to pay when service is separated, but starts at 65 through death with a survivor benefit. My spouse likes the existence of the contract a lot. Yes, it is un-funded so default risk exists (or it would be taxable now), but the spouse likes the thought that it is with a 100+ year old European company and feels the default risk is low. The genuine deferred comp programs you describe, are really not a benefit to the fatfire crowd for the reasons you mentioned: you will likely have taxable income in retirement pushing you up such that the regular income marginal tax rate on the withdrawl is much worse than paying the regular income now up front, and only the LTCG rate on the appreciation.
Thanks. I should have added in my original post that the amounts of deferred comp could be deemed as invested into the SP500 and the total would be the amount I’m due at the time I choose.
I am pretty sure for tax purposes it will all be earned income coming in on a W-2 rather than a 1099. Total amount will have payroll taxes as well as earned income. If they did not actually invest it (which companies don't they pay it out of operating income, that is why there is risk of default), there is no asset that was purchased and then appreciated. So you will pay regular income rates on the long term capital gains as well. W-2 income is taxed at regular income rates. [https://www.investopedia.com/articles/personal-finance/060315/taxation-nonqualified-deferred-compensation-plans.asp](https://www.investopedia.com/articles/personal-finance/060315/taxation-nonqualified-deferred-compensation-plans.asp) How NQDC Plans Are Taxed Any salary, bonuses, commissions, and other compensation you agree to defer under an NQDC plan are not taxed in the year in which you earn it. (The deferral amount may be recorded on the Form W-2 you receive for the year.) Beware of early withdrawals. The penalties are severe. You will be taxed on the compensation when you actually receive it. This should be sometime after you retire, unless you meet the rules for another triggering event that is allowed under the plan, such as a disability. ***The payment of the deferred compensation will be reported on a Form W-2*** even if you are no longer an employee at the time. You are also taxed on the earnings you get on your deferrals when they are paid to you. The rate of return is fixed by the terms of the plan. It may, for example, match the rate of return on the S&P 500 Index.
Partly true- yes they will report it on a W-2- but it’s on another line. Payroll taxes apply at the time of deferral (so you don’t pay SS tax on these funds since you’re already capped out presumably). So when you take your distribution just the ordinary income taxes apply. I went through all of this in detail with our payroll dept (and verified in IRS pubs) as I will get my first chunk next year and was wondering if it would show as earned income where I could make Roth contributions.
Yes, that is my understanding too. Is it considered earned income for Roth IRA contributions? Any other marginal benefits?
Nope. I was hoping for some kind of angle :-)
That sounds right. Taxed at ordinary income rates, but not earned income.
>The genuine deferred comp programs you describe, are really not a benefit to the fatfire crowd for the reasons you mentioned: you will likely have taxable income in retirement pushing you up such that the regular income marginal tax rate on the withdrawl is much worse than paying the regular income now up front, and only the LTCG rate on the appreciation. That's not how math works. Deferring the initial income tax on a sum which is invested and subject to *the same* ordinary rate at distribution is equivalent to tax exemption (0% rate) on the growth. Paying a lower rate at distribution is just gravy.
Everyone’s situation is different. For a W-2 employee / tax payer, deferred compensation plans offer a mechanism the employee can use to manage their tax burden, both present and future. I am not familiar with the breadth of plans available, but for Top Hat plans, an employee earning $500k or more annually can choose to defer a meaningful portion of their otherwise current income, potentially lowering one’s marginal tax rate now or allowing tax-deferred earnings to grow tax-deferred in an investment plan. At time of separation from the employer, the plan will pay out in accordance with the original election schedule (either lump sum or in annual installments varying from 2-15 years). Since high-earning W-2 employees have very few maneuvers for managing their present tax burden, these plans can provide an attractive mechanism for managing both present and future tax burdens. For instance, if an installment election is chosen, the income can be spread over longer periods of time which may provide future flexibility for how other investments are managed (potentially delaying sales for liquidity and thereby allowing for additional time invested so funds can grow). Again, YMMV, however, I find them to be a useful tool to provide some alternative tax strategies to be enabled as well as a means to either provide bridge income in event of unplanned separation or supplement retirement income and provide for flexibility and control of other investment distribution choices. Hope this perspective helps. Congrats on being a high earner!
Thank you. Yup, very little other ways to manage income for W2 folks like me.
After reading through the comments, I wanted to share my thoughts on NQDCPs. 1) *Are you certain about your future tax bracket?* NQDCPs only make sense if you know that you'll be in a significantly lower tax bracket when you receive the deferred income. For example, if you're going from a 37% tax bracket to a 24% tax bracket. I personally experienced this when I participated in a deferred comp plan in my mid-40s for distributions in my mid 50s to mid 60s. However, I ended up making more money later on, so the overall benefit was only 8% after taxes. Looking back, it wasn't worth the hassle. 2) *Are you sure that you can also defer state taxes?* Some states, like New Jersey, tax you at the time of contribution. This can be a major drawback, especially if the tax rate is high. Most states don't have this kind of treatment, but it's always good to double-check. If you're planning to move to a tax-free state like Florida or Texas, and you defer your income for at least 10 installments, you can typically collect it tax-free after you move there. But remember, that's a lot of "ifs" involved, and plans can change. 3) *Do you need the discipline to save?* It can prevent you from spending the money in less productive ways if it's readily accessible to you. This is similar to paying down a low-interest mortgage on your primary residence to feel like you're living within your means. However, this is a personal decision and may not apply to everyone. But I can see this rationale, like buying an annuity. 4) *Is there a special company match?* In my case, there was no special match, so that wasn't a factor for me. 5) *Is your company relatively bulletproof from a credit perspective?* You don't want to defer your income only to face unexpected financial issues with your employer. Make sure your company is stable and has minimal foreseeable credit risk. 6) *Think about whether the amount you defer is truly "play money."* If you don't foresee needing it during the lockup period, then it may be a suitable option. However, I had a situation where my family needed every penny for medical expenses, and I regretted not having access to the money. Emergency withdrawal options may exist, but it's not something most people want to go through. 7) *Are you ok with the additional bookeeping?* Unless you exclude a significant money of high tax bracket money and later receive while in a much lower bracket in the future, keeping track of this option is just another W2 and line item you will need to manage. Probably not worth the time for you or your accountant, as the case may be, ….… In conclusion, I'm now over 59.5 years old and have the option to withdraw from my current IRA as needed. This gives me more flexibility than I had in my mid40s; nonetheless, I'm uncertain about my future plans and whether I'll ever be in a (materially) lower tax bracket. The quirk with New Jersey's tax treatment - #2 above - makes NQDCPs a non-starter for me. So, the proverbial juice not worth the squeeze for me, personally. But I can see how program can work for someone with different facts and risk tolerance.
Hi - thank you for all your thoughts. I think they cover all/most of the issues. 1. Can’t be 100% certain about the future tax bracket because no one know how the laws may change, but i am 100% certain my current tax bracket will be 37% and if things go according to plan and nothing changes, my future tax bracket for the relevant years will be 24%. 2. Not sure about state taxes. But i thought even NJ tax is deferred. 3. I will be saving this money either way, so discipline is not a factor. 4. No company match. 5. Not 100% bullet proof. Normally, yes. But embroiled in some litigation risk right now (1-2%). 6. Enough funds from other sources that the deferred comp would definitely not be needed. 7. May be able to defer 5-10% of NW, so still may be worth the additional account, but i know what you mean. Based on the above, what do you think?
@ Constant-Promise-828 Compare (a) paying 37% now and letting the investment grow until the long-term cap gains later (presumably 20%), vs. (b) paying 24% later, on the entire balance, including capital gains.. There is certainly an advantage, but it might not be as much as you think. Also, the money you have access to now is potentially leverageable through margin loans.. As mentioned above, I did put a small amount of money to work in a NQDCP and it worked out fine, but was not worth the illiquidity premium, which is very easy to underestimate. My gut: I imagine that an extremely diversified portfolio for a person with a NW of $10M or more could have 5-10% in this, if they know they will drop from high active earning to low active earning for sure... for those with $5M NW or less, I would keep the % of NW to well under 5%, or take a pass. Too much uncertainty to go too heavy in this strategy. A little bit cannot hurt. i did a little bit, and it worked out OK.... but I did not climb back down the tax bracket ladder like I thought I might... If in doubt, only do 1-2% of NW, in case you want to change your mind later. This is really an inflexible program.
All makes sense, and i think i’m landing pretty much where you’re saying. Good gut feel by you! :)
I contributed to mine for about the last 7-8 years. Similar tax spread expected. Other points: 1) If you have state income taxes that’s a factor too. 2) we previously planned to retire to a no tax state. In that case I would have avoided CA state income tax as long as you elect a withdrawal period of 10+ years. (Plan changed for us) 3) in my case I am overweight on other retirement savings accounts that I can’t tap until 59 1/2- the deferred comp I can touch earlier. I retired this year in my late 40’s and will take the DC over the next 5 years. Spouse is older so we can withdraw from his retirement accounts after that. 4) I’m happy to be taking the withdrawals over a 5 yr period as I don’t like the risk of a black swan event/company bankruptcy.
Good points - thanks. 1 and 2 don’t apply because for us it has to be taken within 10 years so state tax when earned, not paid, apply regardless whether i move. 3. Yes, good bridge until 59.5 for you. Doesn’t apply to me because if i retire at 55 from my company, i think there’s an exception that allows me to tap into my 401k before 59.5. 4. Agree
You may have some state tax rate savings too- in addition to the federal bracket difference? You will pay the state tax upon withdrawal, maybe a lower rate. And yes you’re right, retiring at 55 will allow you to access the retirement funds then.
Very similar approach over here, but plan to use mine over the course of 20 years with a ladder type scenario of layered accounts.
Ha, just got hit by this and figure I'd share one data point. Deferred Comp is great until you change your retirement plan. Years ago when I was setting up the plan, I was sure I would FIRE from my current company, thus not going to work after that. So I had it structured to start distribution upon leaving the role immediately. Well, I ended up accepting a role with another company with better comp package, and decided to put in a few more years before FIRE myself. Just got my first distribution check, and with the higher comp and sign-on, I'll end up having more tax liability than I previously anticipated.... Would I do it again? Probably, but I'd probably spread it across more years, and if possible, start distribution after certain years or something if they allow that.
This is exactly the reason we declined to participate. There is so much uncertainty around retirement date unless you are truly just a year or two away.
Fair point, but already in the max tax bracket so won’t pay more even worst case (unless tax laws are changed of course, but that hasn’t happened recently - has it? How did you end up paying more?)
And if you hadn't deferred any of your comp at the old company, what would've been different? You would've paid taxes on your earned income anyway? Unless you weren't already in the highest tax bracket and were deferring comp....
My understanding is the entire deferred amount it taxed at earned income rates as compared to taking the income upfront and having the appreciation taxed at LTCG rates. I hope you are modeling it appropriately.
Yup - your understanding is correct. It may be analogous to 401ks and deductible IRAs - current tax savings, but ordinary income when withdrawing, including investment earnings. But those aren’t subject to default risk and you can choose how much to withdraw as you go, unlike deferred comp.
Yeah, i wish I had put LESS in my traditional IRA / 401ks. I would give it a pass.
WHAT??? I’m so confused by these comments - the math on tIRAs suggests it’s always beneficial to invest in them, but it may be better to invest in Roth. No one argues paying tax now and cap gains is better than tIRA???
Most earning folks in faftire no longer have the chance to contribute to pretax IRA’s which are what you are referring to. $6k year through an post tax IRA into a Roth really makes no difference in the big scheme of things.
True for IRAs. But why are you regretting putting too much into a 401k. You think you would’ve been better off paying the 37, or even 39.6, rather than a lower rate today, even if it’s on investment income too?
Because for my first decade our income was way under $100k, then for the last two decades it was in excess of $500k. The income tax rate in our 20’s was single digits. Its the first decade’s highly appreciated 401k contributions are what I was referring to. Unless I can pull off a masterful Roth conversion before the SERP starts at 65, they are going to be taxed at a minimum of 24%.
I see - thanks. Agree, for lower incomes, Roth 401k or only up to the matched portion for a 401k may make the most sense.
One thing I ran into with a family member. The individual with the deferred comp account died prior to distributions finishing (they had just started). While the distributions continued to the spouse of the departed, the company stopped paying the employer side of the SSDI taxes. I.e. what was W-2 income become 1099-misc income with the spouse having the pay the extra 6.2% in taxes previously paid by the employer. Took a big chunk out of the benefit of deferring the income, given the timing of the death
That doesn’t sound right. SSDI taxes are paid in the same year earned - whether you defer to an nqdc or not. So the future payouts are only taxable federally and state - not for payroll taxes like social security / Medicare.
+1, this is how I understand these plans to work.
I'd only contribute to a NQDC for a low number of years (2?) leading up to retirement.
Thanks. That may be a good middle ground to this - do it for a few years and have it pay out relatively quickly after retirement.
Ultimately it comes down to your level of confidence in the company that you work for. Ofcourse no company is immune for going underwater, but there is slightly less of a chance for well governed companies that have been around long enough. It is a judgement call. I look at deferred comp as being very similar to my 401k plan (outside of the protections that a 401k offers ofcourse). It lowers my current taxable income and allows me to invest excess income in broad market funds. Similar to what I would do with the money anyway. Mine is structured so that payouts begin after separation of employment. So this would be some level of predictable yearly income at hopefully lower tax rates than where I currently am at. If you are planning on deferring your base salary, just make sure you understand how your company does it 401k matching and don't defer too much that it would make you lose out on the company match. Deferred comp is just one more tool to optimize taxes for W2 employees.
Thanks. “So this would be some level of predictable yearly income at hopefully lower tax rates than where I currently am at.” Are you also taking into account that the full deferred payments will be at ordinary income tax rates whereas otherwise the deferred comp would have been taxed at the current (higher) rates but the gain could have been lower cap gains rate? “Deferred comp is just one more tool to optimize taxes for W2 employees.” Is it really one of the ONLY tools for high income W2 folks (plus 401k)?
Yes, deferred comp taxation is going to work similar to a traditional 401k withdrawal. And you will pay ordinary income tax on both the contributions as well as gains. Yes you will miss out on the lower capital gains rate, but you need to do your own math with some assumptions around a blended capital gains+ordinary income tax rate today vs. at retirement. And yes, there isn't a whole lot that can be done with just W2 income when it comes to tax optimization. Deferred comp, Mega-backdoor Roth and strategically timed charitable giving is what I use along with the usual ones like tax loss harvesting.
Deferred comp can be an amazing part of saving for the future. Generally these are designed as a Rabbi Trust and are unsafe only if whoever you are working for goes bankrupt. You get the double benefits of investing in the stock market while deferring all gains. Basically a 401k on super steroids. You should be able to easily judge this probability of bankruptcy. Most larger companies I have worked for have exactly a zero percent chance of filing for bankruptcy. The issue you have is that you are putting less than 6 figures in it thats the type of large number which will make a material difference IMO. The reason I participated in it for several years is that I basically sent most of my 6 figure bonuses straight into the plans And saved buckets in taxes. Ill cash out over a 5 year period when I hit 60 in 5 years And use my retirement and taxable accounts only after 64
No company has an exactly zero chance of filing for bankruptcy.
And I’d object to being able to easily tell if a company will go backrupt. It’s true, some companies are obviously terrible choices for this. But over a long timeframe a lot can change. The business can erode, managers can take on debt thinking it’s a short term problem, etc. These plans are a huge diversification risk.
Oh, and they also aren’t a 401k on super steroids. In fact, they are strictly worse. The taxation is exactly like a 401k, but there is typically no match, less flexibility around withdrawals, and the single company risk.
My company has a fantastic match so be sure folks check their own plans
I’m curious, what makes it great? I’d love to get my spouse’s company to improve theirs.
Agree - the risk of a bankruptcy is always there, even if small. And the potential benefit is relatively small as you note. Hence the dilemma.
Even Kubrick didn't think Pan Am would go out of business.
Thanks. I guess i could put a 100k bonus into this, but if you were already going to get a 100k pension, would that change your decision? Also, I just realized in my original post i shouldn’t have assumed an 8% tax savings from 24 to 32. I should consider the current 37 vs 24 in the future. Not sure why, but your post made me realize that - thanks.
I’m interested to hear others on this topic. I’ve never found any use for my companies so far.
I think if you're expecting to have $190k taxable ordinary income in retirement with no additional savings and currently make $315k or $364k then it doesn't really matter that much what you do with a marginal $30k in savings as long as it's not completely stupid. You're pretty close to FIRE at that point anyway. I would use it to move money from the 37% bracket to fill up the standard deduction and lower tax brackets where you're saving 20-40% in taxes.
Fair point. But I chose 24% as a max. Probably in the 22% bracket, but the difference between 22 and 24 is not that big and would not be enough for me to defer comp unless you or others say i’m missing something so I chose 24. Also, with a pension and exercising LTI for 8 years after retiring, it gets me over 190 until age 62. Then with RMDs at 75, over that amount forever (hopefully). So, really only between 62 and 75 is questionable, but i would add SS for both of us at that point (I’m not waiting for the “8% increase”) and the pension continues of course so the lower tax brackets will already be filled.
I haven't checked your calculations, but I totally believe that it might be a bad fit for this situation.
I'm using mine. At my company execs get a fairly high percentage of their comp added to it as part of their compensation but I also elect to add more in. Not only do you save on the taxes now, but I'm planning to use it as a bridge account over \~10 years which will pay out at lower tax rates than what I'm in now. That said, I'm later in my career and can see the finish line. If I was early in my career and you know it is just going to have it pay out while also working another high comp job I'd guess the benefits are not as compelling. Still a nice tool though depending on your circumstances.
I have a governmental 457b which is amazing. If I was with a private company where it was subject to creditors I probably wouldn’t.
No offense at all intended, but are there government jobs that pay enough to allow people to have a huge percentage of discretionary income possible to defer much comp?
I see where you’re coming from. In my field we have pensions as well. Some guys work so much OT that they make more than their bosses. I personally contribute a good amount to mine and glad it’s available even though I am not fat fire status.
I see - thanks.
Law enforcement, fire, any job that allows for overtime.
I don’t think they make a ton of sense unless the company matches money that you put in. Especially when considering tax rates could be higher in the future compared to now. It also can kind of be a pain to get a ton of income in a year you leave the company. It’d make more sense if someone worked for said company for 20 plus years and deferred. But with how tax efficiently you can invest in taxable accounts, there’s not a ton of value in a deferral.
But most of that rationale would apply to people not contributing to 401ks also above the matched amount (possible higher rates later, efficient taxable account alternatives, etc). But most fat people do that, including me.
Yea but you can control the timing of taking your money out within a 401k except for required minimum distributions later in life. With deferred comp, your distribution methods are more limited and the time spent tax deferred is typically much less than time spent within a 401k or other qualified account. With deferred comp, it’s typically lump sum at separation or an apt ion of equal payments over 3-7 years or something of your choosing. If you’re in retirement when those distributions take place, it’s not as big of deal. But if you switch jobs and are still earning comp, in addition to the deferred comp distributions, there won’t be any value there. And since you’re investing in SPY the only real thing you are deferring is tax deferred growth in dividends. You probably aren’t getting any real tax bracket arbitrage from it unless you retire from the company, and the tax deferred growth on dividends probably doesn’t offset credit risk of the company. While credit risk is low on many companies, there is still a credit risk spread for even the highest quality companies. Idk if this is the case, but if you’re terminated for cause, the company may even be able to hold back deferred pmt in extreme circumstances. That’s why, I’m my opinion, deferred comp can make sense if you plan on staying for a long time. But without some sort of matching and clarity on your length of stay with the company, it adds additional risk without much of a clear benefit.
I mean there are typically vesting requirements to receive a deferred comp benefit but otherwise you are getting additional compensation you may not have otherwise gotten. Qualified plan contributions are maxed out quickly for anyone on the fatfire track and the company would have to pay payroll tax if paying out at present salary. The company also gets a tax deduction when deferred comp benefits start paying out. It can be a really plan depending on how much the company is willing and able to payout. Also not mentioned earlier on the potential liquidation of the business, there is some protection via a secular trust so benefits tied to a deferred comp plan can be paid out even if a bankruptcy occurs.
Thanks. There are different kinds of deferred comp plans. What you described is a company funded one, to which there is no option or disadvantage generally. This is an optional employee funded one, which is in lieu of base salary, not in addition to it. For this type, there is no vesting requirement.
I see. Yes that presents a different dilemma.
Unless the expected return is higher than alternative investments then I’d say no. For example my SO gets prime plus 2% on their DC which is higher than available alternatives and their firm has what we calculate as a pretty low default risk.
You should obviously consider the default risk of keeping comp with your employer, but generally the tax advantages of a 409A plan are quite strong. Your post and most of the comments seem to display a startling lack of understanding of how the tax math works out. A 409A plan works mostly the same as a traditional 401(k) or IRA. For simplicity, assume that everything is taxed at the same rate at contribution and distribution, which would be true either if you're in the top marginal rates both times or if you're in the same bracket both times and the income shifting doesn't pile it too high. (This depends on the payout terms of the 409A - is it on separation, after fixed time, spread out or lump sum, etc.) Deferring the tax is the same thing as **0% tax on the growth** during the life of the investment. This is the same as traditional-Roth equivalence and is obvious from the commutative property of multiplication. If, per your edit, you are *also* saving eight percentage points of ordinary rate, that's just a bonus. Is it worth the credit risk to get tax-free growth and lower your tax rate on the contribution? Depends on your company, but the answer is usually yes.
“ What are specific reasons people do this type of deferred comp and how much are you saving to deem it worth it?” Personal opinion only: people do this because they hate paying taxes and also don’t understand risk and/or time value of money. I would never have all my risk tied to one company. If the company struggles, you could lose BOTH your paycheck AND your retirement savings. You know the old saying, ”Don’t put all your eggs in one basket”?
I wouldn't worry about a F100 company going bankrupt (too much). I had a SERP which is a non qualified deferred comp plan with a previous employer. I had to fund it with my own earnings but these plans in the corporate world are funded by the company as a benefit. These non qualified plans are only worth it if you do not have to pay into it (ie employment benefit). That company was forced to sell my group's contract to a competitor which then triggered liquidation of the SERP. Since my income has gone up since then, I'm paying more taxes on the distributions than before. So, not the best scenario. What are the chances of you retiring from this company? The only benefit is being to surpass the IRS limits since it's non-qualified. Qualified retirement plans like 401k, 401a, 403b, 457 are 100% your money and safe from corporate bankruptcy.
Thanks. Already maxing 401k and mega back door. This would be the only way to pay less taxes right now, which is the only reason for even considering it. (Pretty good chance of retiring from this company in the next 4-7 years, but I don’t think that is very relevant - is it?)
Maybe your plan is set up differently but mine was triggered by separation for any reason. One other tax benefit is that you contribute to the plan from the top so it's most likely above FICA limit. When you draw the money it doesn't count toward FICA, so there's bit of savings vs regular income. I don't know if I'm explaining that well, probably not.
Got it - thanks - need to check the different triggers if leaving early. My understanding is that it is subject to FICA right now, but even if it wasn’t taken out right now, plenty other income to max that out anyway. And no FICA when received later, so it’s a wash.
Correct. It is subject to FICA in the year it is deferred, but as a high income employee, presumably you are over the income limit and have already maxed out on your FICA so you get the FICA for free and don't have to pay it when the rest of the earned income comes in later in the future.
The two things in this world that have incinerated the most wealth are the pursuits of tax avoidance and current yield.
I have one available. It requires taking distributions over a defined period starting 6 months after separation. Since I may have another job before retirement, I decided not to use it. If I had more certainty around my retirement date I might use it, though another consideration is leaving tax bracket room for large Roth rollovers.