Understanding Deferred Compensation: Factors to Consider
In the complex world of financial planning, deferred compensation is a common topic of discussion. Simply put, deferred compensation is a form of compensation that is designed to allow a designated group of executives to save beyond standard 401(k) contribution limits. Deferred compensation plans are highly customized by each employer. Most plans restrict distributions until employees reach a specified milestone, such as a certain age, years of service, or retirement. The implementation of such plans involves several considerations that may not be obvious. Before participating in a deferred compensation plan, consider the following factors.
Taxable income consideration now and in retirement
Your taxable income is one of the key aspects to consider when determining if you should contribute to a deferred compensation plan. If your current income is high, a deferred compensation plan may make sense because your contributions reduce your taxable income and may lower your tax burden. But careful planning is necessary to help manage your taxable income in retirement to avoid exceeding certain thresholds that may require you to pay more taxes than you had planned to or can afford.
Review cash flow needs during working years and nearing retirement
It is important to consider your cash flow needs during the working years and compare those to your cash flow needs in retirement. Deferred compensation plans typically pay benefits in installments over a specified time period, such as 10 years. Determining which payout structure works best for your needs is critical. Additionally, it’s important to consider whether other sources of income, such as Social Security and pension plans, can provide the desired cash flow during retirement.
Consider concentration risk in any investment in deferred compensation plans
Since deferred compensation plans do not provide guaranteed income, it’s important to consider concentration risk when evaluating the investment options offered by your employer. Concentration risk is the potential for losses when a significant portion of your portfolio is invested in a single asset or stock, such as your employer’s stock. Although concentration may potentially benefit returns in some market environments, it also increases the risk of losses. A diversified portfolio can help mitigate concentration risk.
Deferred compensation plans differ from 401(k) plans
It’s crucial to know the differences between 401(k) and deferred compensation plans. Deferred compensation plans are generally less flexible than 401(k) plans and do not have the same legal protections as other retirement accounts. However, deferred compensation plans can offer a much higher income tax deferral than what a 401(k) allows. Explore all available options to determine which plan best aligns with your needs and goals.
There are several factors to consider before signing up for a deferred compensation plan offered by your employer. By reviewing taxable income, cash flow needs, concentration risk, and the differences between deferred compensation and 401(k) plans, you’ll be better positioned to evaluate these options as part of your overall financial planning process. Seek personalized advice from a qualified financial professional who can tailor a strategy to your specific goals and circumstances.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. Please consult your investment professional regarding your unique situation.