Over the past several months I have seen an increased amount of nonqualified deferred compensation plans being offered at the workplace. These types of plans are often misunderstood by the employees that participate in them, and most of their decisions are made from discussions with their colleagues at work.
When families build out their overall financial plan, they generally have the two phases of accumulation and decumulation. The challenge with deferred compensation plans is that most families can easily see the tax advantages in the short term, but don’t consider how the income will be received in the long term when they check off their elections for receiving money down the road.
First things first, when it comes to signing up for deferred compensation plans at work. You should be sitting down as a family and carefully calculating the best strategy to minimize your taxes while not destroying your family cash flow. Sometimes it will be best to rob Peter to pay Paul if you have a lot of money in the bank depending on your personal situation. Remember, that different deferred compensation plans will offer various investment choices from fixed accounts to stock market type investments. The nonqualified deferred compensation plans are also subject to creditors of the company should the company go bankrupt. That is another important consideration you should make before you go into the plan.
The key election participants have to make (and you can usually change this every year for every contribution) is the methodology on how you will receive income down the road. You will generally have the ability to take the cash as a lump sum, a three year election, a five year election, or a ten year election down the road. Considering that you have never received constructive receipt of this income, so the Government will eventually want their tax dollars. This is why you won’t see a lifetime election. You may also have the ability to decide when your first payment will begin from the deferred compensation plan. For example, if you separate service on January 1st, you could tell your company that July 1st will be the first date to start your installments.
These decisions need to be carefully planned out, because if you chose a lump sum election and you get a gigantic severance package from your company you might actually have defeated the purpose of doing the deferred compensation plan which was to save money in taxes.
It’s best to get a professional opinion or strategy laid out by your financial advisor or CPA when you elect to get involved with a deferred compensation plan. If you manage the plan effectively, you could reduce your tax liability substantially in retirement.