Should You Invest in a Deferred Compensation Plan?

Whether or not you should invest in a deferred compensation plan depends on several factors related to your personal financial situation, the specifics of the plan, and your future goals. Here are some considerations to help you decide:

1. Tax Benefits

• Immediate Tax Deferral: One of the main advantages of a deferred compensation plan is the ability to defer taxes on the income you contribute to the plan until you withdraw it, typically in retirement. This can lower your current taxable income and reduce your tax burden in the short term.
• Future Tax Rates: The key consideration here is whether you expect your tax rate to be higher or lower in retirement. If you anticipate being in a lower tax bracket when you withdraw the funds, the tax deferral can be a major benefit. If you expect your tax rate to rise, you might want to reconsider or limit your participation.

2. Employer Match/Contribution

• Some deferred compensation plans offer an employer match or contribution, which can significantly enhance the value of the plan. If your employer is offering this, it’s often worth contributing at least enough to take full advantage of any matching funds, as this is essentially “free money.”

3. Investment Options and Fees

• Investment Choices: Deferred compensation plans may offer a range of investment options, but the selection can vary widely depending on your employer’s plan. It’s important to understand what options are available (e.g., mutual funds, target-date funds, etc.) and whether these options align with your investment goals.
• Fees: Some plans charge management or administrative fees that can eat into your investment returns. You’ll want to understand these costs and evaluate whether they’re reasonable in comparison to other investment vehicles, such as an IRA or 401(k).

4. Risk of Employer Solvency

• A major drawback of some deferred compensation plans is that they are typically unsecured, meaning they are not protected by the same legal safeguards as other retirement accounts (like a 401(k) or pension). If your employer were to experience financial difficulties or bankruptcy, you might risk losing the funds you’ve deferred. This is particularly true for non-qualified deferred compensation plans (NQDC), which are different from 401(k)s or IRAs.
• Qualified vs. Non-Qualified: Ensure you understand whether your plan is a qualified or non-qualified deferred compensation plan. Qualified plans are more protected under federal law, while non-qualified plans can carry more risk.

5. Access to Funds

• Deferred compensation plans typically don’t allow you to access your money before a designated date (often retirement). While this can be a benefit for people who need a forced savings vehicle, it may be a downside if you anticipate needing liquidity before that time.
• Early Withdrawal Penalties: In some cases, early withdrawals may come with penalties or unfavorable tax treatment.

6. Retirement Planning and Diversification

• Deferred compensation plans can be an excellent tool to supplement other retirement savings accounts, like a 401(k) or IRA. However, if you are already heavily invested in your employer’s stock or have a significant amount of your net worth tied to your job, you may want to consider how much additional exposure you want to your employer’s financial well-being.
• Diversification: Ensure that you’re diversifying your retirement investments to mitigate risk. Relying too heavily on a single company’s stock or financial health can be risky.

7. Alternative Retirement Savings

• Compare the deferred compensation plan with other retirement savings options, such as a traditional IRA or Roth IRA, which may offer more favorable tax treatment or greater flexibility in how you invest and withdraw funds. You should also consider your current 401(k) plan, if available, which might offer a more secure tax deferral along with employer matching.

8. Timing and Flexibility

• Timing of Distributions: Some plans allow you to specify when you want to begin receiving distributions (e.g., at retirement, after a certain number of years, or at a specific age). Understanding when and how you’ll be able to access the funds is essential for your financial planning.
• Flexibility: Certain plans allow you to change the timing of your deferrals, while others do not. If you foresee a need for flexibility, make sure you understand the terms of your deferred compensation plan.

Bottom Line

A deferred compensation plan can be a valuable tool if you’re looking for tax deferral, have a high-income year, or want to supplement your retirement savings. However, it’s crucial to balance the benefits against the potential risks—especially the lack of protection for non-qualified plans and limited access to funds. You should also ensure that you’re not over-concentrating your wealth in your employer’s stock or facing large fees within the plan.

If you’re unsure about whether to participate, it might be helpful to speak with a Savant financial advisor who can help you evaluate your current financial picture and future needs.

Matthew P. Witter Financial Advisor CFP®, CEP, ChFC®, AIF®

Matt specializes in guiding senior level executives of public companies toward personal financial peace of mind. More specifically, he helps manage the complexities of their stock-based compensation.