Deferred Compensation: Tax Strategy or Tax Trap?

Deferred Compensation: Tax Strategy or Tax Trap?

By Justin Gillette, CFP®, CPA

What Is a Nonqualified Deferred Compensation Plan (NQDC)?

A nonqualified deferred compensation plan is a financial strategy that allows individuals to elect to defer a portion of their wages, whether in the form of a certain percentage or a fixed dollar amount. This deferral offers certain tax advantages with individuals being able to deduct their contributions, which grow tax-deferred until distribution. The theory behind this approach is to enable high-earning individuals to save on taxes during their peak earning years and withdraw the funds during retirement when they are expected to be in a lower tax bracket. However, as this article will delve into, there are several considerations that temper the appeal of these plans.

The Advantages of NQDCs

1. Tax Deductions: One of the primary benefits of NQDCs is the immediate tax deduction. By deferring a portion of their income, participants can reduce their current taxable income.
2. Tax-Deferred Growth: The contributions to these plans can be invested, and the earnings grow tax-deferred. This can enhance the long-term growth potential of the funds.
3. Flexibility: NQDC plans are highly flexible. Participants can tailor the amount they defer to match their unique financial goals and needs. This level of customization makes NQDC plans particularly appealing for high-earning executives with fluctuating incomes.

The Drawbacks of NQDCs

1. Creditor Vulnerability: A significant drawback is that NQDCs are subject to creditors of the sponsoring organization. In the unfortunate event of bankruptcy or legal action against the employer, participants could be at risk of losing their deferred compensation.
2. Taxation on Distribution: Upon distribution, all funds from NQDCs are taxed as ordinary income. This means that they are taxed at the participant’s marginal tax rate, which is typically higher than capital gains rates.
3. Limited Investment Options: These plans often offer a limited selection of investment options. Participants may have restricted choices for how their deferred funds are invested.
4. Liquidity and Access: These plans are not liquid. Once you elect to defer, funds are typically inaccessible until a specified distribution event such as retirement, termination, or another qualifying event. Changing these elections later is extremely limited under 409A rules. This can lead to unfavorable tax consequences in certain scenarios.
5. FICA Taxes: You are still obligated to pay Social Security and Medicare taxes (FICA) in the year your income is earned, even if it is deferred.

Navigating the Tax Conundrum

Consider an executive earning $360,000 annually who defers 20% ($72,000) of their salary into an NQDC plan for five years. Over that period, they save about $86,400 in federal taxes (at a 24% marginal rate) and grow their NQDC account to roughly $425,000.

When enrolling in the NQDC, they elected to receive the payout in the year of retirement or termination. Unexpectedly, they are terminated and receive a $360,000 severance while starting a new job paying $250,000. This results in $610,000 of income from wages and severance plus the $425,000 NQDC payout for a total of $1,285,000 of taxable income all in the same tax year.

Under 2024 tax brackets, $121,200 of the NQDC payout is taxed at 35%, and the remaining $303,800 at 37%, creating an additional $154,826 in taxes. In short, the tax hit on distribution far exceeds the original tax savings, illustrating how timing and payout elections can dramatically affect outcomes.

A Deeper Tax Rate Outlook

We are currently in one of the lowest individual tax rate environments in recent history. While contributing to a nonqualified deferred compensation plan can reduce taxable income today, it’s important to recognize the potential for higher tax liabilities in the future. Although the One Big Beautiful Bill Act (OBBBA) made current individual tax rates permanent, Congress retains the authority to change tax laws at any time. Historically, tax rates have fluctuated, and there is a strong possibility that rates could increase in the future. As a result, deferring income now may lead to paying more taxes later if rates rise.

Bluerock’s Guidance

Given the intricacies and potential risks, we generally recommend contributing any amount that your employer will match.  It’s prudent to consult with your Bluerock Advisor to make informed decisions about nonqualified deferred compensation plans. The specific financial situation of each individual should be considered before determining the best course of action.

Justin Gillette, Senior Wealth Manager

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.