The Pros and Cons of Deferred Compensation
By Trent Derrick, CMT®
Imagine having the flexibility to save and grow your wealth while enjoying potential tax advantages. That’s the allure of deferred compensation plans, a popular option for high-income earners seeking to optimize their financial strategy. However, as with any financial decision, there are pros and cons to consider. From the potential for tax deferral and enhanced retirement savings to the complexities of vesting and timing, navigating the option of deferred compensation requires careful consideration.
Let’s explore the pros and cons of deferred compensation, helping you make informed choices that align with your long-term financial goals. Read on to understand the benefits and potential downsides while we pave the way to a successful financial strategy.
The Benefits of Deferred Compensation Plans
For highly paid professionals, deferred compensation plans can be a good way to save for retirement after maxing out contributions elsewhere because deferred compensation plans have no contribution limits. Consider these additional benefits:
Tax Mitigation Strategies
Do you live in a state with high-income tax but are considering retiring to a state with no income tax, like Florida? Deferred compensation plans help you save on your tax bill by allowing you to put more money into your plan and potentially lower your tax bracket while you are working. You will not owe federal income tax on the funds contributed until they are withdrawn in retirement, typically when you are in a lower tax bracket. Additionally, if you are planning on moving to another state without an income tax for retirement, this could also provide some tax savings.
Retirement Income Bridge
Deferred compensation plans can be used to generate income for a couple or individual as they begin retirement and want to maximize their Social Security income by delaying collecting it until your full retirement age. It can also be used to supplement income in retirement if the market has taken a hit and your portfolio has suffered.
Deferred Compensation Plan Drawbacks
While the pros of deferred compensation plans seem like incredibly useful tools for your wealth management strategy, there are some points to consider when using a deferred compensation plan.
Company Solvency Risks
This may be the largest risk you can face when using a deferred compensation plan. If a company declares bankruptcy, your deferred compensation plan could be completely or partially dissolved in the bankruptcy. This is because when you participate in a deferred compensation plan, you are considered to be a creditor of the company. Also keep in mind that if you choose a longer-term payout option, this increases the risk that the company may go bankrupt during this time. You should closely examine your company’s plan and consult a trusted financial advisor before participating.
Lump Sums Could Affect Your Taxes
Most plans do not allow you to access the money earlier than your retirement, however, if you change jobs, you may have to collect the money in one lump sum. Collecting one large lump sum could wreak havoc on your tax mitigation strategy for that tax year.
Lack of Diversification
Deferred compensation should always be coupled with other retirement strategies that don’t involve your company. This is because as an executive, you may have an inordinate amount invested in your employer’s stock. If the company suffers an economic blow, your employer’s stock could lose value and your deferred compensation plan could also be in jeopardy. This could be devastating to your retirement plan.
A Financial Planning Partner
Navigating the complexities of deferred compensation plans can be daunting, but you don’t have to go it alone. At Legacy Wealth Management, we are dedicated to supporting our clients throughout their retirement planning journey. With our knowledge and experience, we can help you understand the intricacies of deferred compensation and develop strategies to safeguard your wealth management plan. Our focus is on the long term to provide the guidance for you to make informed decisions about your financial future.
If you’re interested in exploring our approach to financial planning and determining whether we are the right fit for your needs, reach out to us to book a consultation with me here or email me at trent@legacywm.com. Let’s connect and start building a successful financial partnership together.
About Trent
Trent Derrick is a financial advisor and Chief Market Technician at Legacy Wealth Management. Trent is passionate about the value small businesses bring to their communities and specializes in serving small business owners by providing seamless financial advisory services tailored to their financial needs, including tax planning, cash flow management, retirement planning, and bookkeeping. Trent has a bachelor’s degree from the College of Charleston and studied economics at the University of South Carolina, Columbia. He is a Chartered Market Technician® (CMT®) professional. Trent serves as a guest lecturer for the College of Charleston’s MBA program and acts as chairman of the Market Technician Association’s Charleston chapter. When he’s not working, Trent, a proud Eagle Scout, enjoys volunteering with the Charleston Animal Shelter’s outreach program. Trent and his wife love to cook international cuisines and host dinner parties with their friends. To learn more about Trent, connect with him on LinkedIn.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Legacy Wealth Management and LPL Financial do not offer tax advice or services.
This material was prepared for Trent Derrick’s use.