Deferred compensation elections

In short

If you are drawing a big paycheck, you have probably noticed how much of each raise goes to tax. A nonqualified deferred compensation plan lets you tell your employer, before the year begins, to hold back part of your pay until a later date. You pick the amount and the date. Tax on that money waits until you receive it. The catch is that the money stays your employer's property until then, so you are trusting the company to pay. Make your choice before the deadline, because it usually cannot be undone. Write down your payout dates the day you sign.

The whole of it

What it is

A friend of mine, a hospital administrator, once told me she felt rich on paper and cash poor in her head. She was earning well, yet every spring she wrote a large check to the tax collector. Her employer offered a deferred compensation plan, and she did not understand a word of the packet. So let us walk through it together, slowly, like two neighbors with a folder between us.

A nonqualified deferred compensation plan, often shortened to NQDC, is a written agreement between you and your employer. You agree to be paid some of your salary or bonus later instead of now. "Nonqualified" just means it does not follow the same rules as a 401(k). It is not a retirement account that the law protects for you. It is a promise from your company.

Plans like this are usually offered to higher paid workers and executives. Many employers keep the invitation list small. If you got a packet, your employer thinks well of you. That is worth a moment of quiet pride.

How it works

If you are holding the enrollment form, here is the order of things. First, you choose how much to defer, either a percent of salary or of a bonus. Second, you choose when the money will be paid. That might be a set year, your retirement, or a fixed number of annual installments. Third, you sign before the election deadline.

That deadline matters more than anything else on the page. Under Section 409A of the Internal Revenue Code, you generally must make the election before the year in which you earn the pay. Bonuses that depend on performance over at least twelve months can sometimes be elected a little later. The plan document will say which rules apply to you.

Once you sign, the schedule is hard to change. You cannot simply ask for the money early because the roof leaked. Many plans allow payment only at the planned time, at separation from service, at disability, at death, or in a true unforeseeable emergency. If someone changes a payout date, the rules usually require the new date to land at least five years later. Breaking these rules is costly, and I will come back to that.

Now the part that surprises people. Your deferred money is not held in a trust that creditors cannot touch. Most plans are "unfunded," which means the money is a bookkeeping entry. Your employer may set aside assets to match the promise, often in something called a rabbi trust. Even then, those assets stay reachable by the company's creditors if the company fails. You are an unsecured creditor. That is a plain way of saying you stand in line with everyone else.

Many plans let you pick notional investments, which are pretend funds that track real ones. Your balance rises or falls with your picks. The funds are not really yours. The account is a scorecard.

Tax works like this. You owe no income tax on the deferred amount in the year you earn it. You owe income tax when it is paid to you, at the rate that applies in that year. Social Security and Medicare taxes work differently. They are usually due when the pay is earned or becomes vested, which means no longer at risk of forfeiture. The Social Security part stops once you pass the yearly wage base, so deferral does little there for a high earner. Medicare has no cap.

The numbers, and where to find yours

I once watched a man sign a form in a hurry and then spend a year wondering what he had signed. Let us not do that to you. Some numbers come from law, and some come from your plan.

The law sets a few. The Social Security wage base for this year is the current figure, which the official source publishes each year. The top federal income tax bracket rate is the current figure, which the official source publishes each year, and it starts at an income of the current figure, which the official source publishes each year for a single filer. Additional Medicare tax of the current figure, which the official source publishes each year applies above the current figure, which the official source publishes each year of wages. The IRS publishes these figures each year, in Publication 15 for payroll rules and in Revenue Procedures for the brackets. The Social Security Administration posts the wage base on its own site.

Your plan sets the rest. Look in the plan document and the enrollment packet for your election deadline, your allowed deferral percent, your payout options, your vesting schedule, and the list of notional funds. Also look for any employer match. Ask human resources for the "summary plan description" or the "plan document." They are required to give you something in writing. Short version: get it on paper.

A worked example

Let me tell you about Marcus Webb. He is a sales director, fifty two years old, who earns a salary of 240,000 dollars. His company also pays a bonus of 60,000 dollars. In November he elected to defer 10 percent of his salary and 50 percent of his bonus for the coming year.

Here is the math, with every input shown. Ten percent of 240,000 is 24,000. Fifty percent of 60,000 is 30,000. Added together, 24,000 plus 30,000 equals 54,000 dollars deferred.

For round numbers, say Marcus pays federal income tax at 35 percent on his top dollars this year. Tax he avoids this year is 54,000 times 0.35, which is 18,900 dollars. That is the tax he does not pay now.

Marcus chose to be paid in five equal yearly installments starting at age sixty five. Suppose, to keep it simple, the balance did not grow at all. Each installment is 54,000 divided by 5, which is 10,800 dollars. Suppose he expects a 24 percent bracket in retirement. Tax on each installment is 10,800 times 0.24, which is 2,592 dollars. Over five years the tax is 2,592 times 5, which is 12,960 dollars.

So the gap is 18,900 minus 12,960, or 5,940 dollars. That gap is the savings from the lower retirement rate. Marcus does not know today what his rate will be then, or what Congress will do. His plan was a guess, a reasonable one, but a guess.

Now the quiet worry. Marcus also has to ask whether his company will still be standing in thirteen years. He read the company's financial statements. He asked what assets back the plan. He decided the promise was good. You would want to do the same.

Where it goes wrong

A neighbor of mine once lost a good chunk of a deferred account when his company went bankrupt. He had been a loyal worker. He stood in line with the other creditors and got cents on the dollar. It is a hard story, and it is the main risk. Your money is only as safe as your employer's ability to pay.

The second trouble is the tax rule itself. If a plan breaks Section 409A, the deferred amount can become taxable in the year it vests. You may also owe an extra 20 percent tax on top, plus interest. The IRS explains this in Notice 2008 113 and in the regulations under Section 409A. Most of the time the employer drafts the plan to follow the rules. The danger comes when someone changes a date or accelerates a payout by hand. Don't improvise.

Third, tax rates can rise. Your savings depend on being in a lower bracket when you collect. If rates go up, or if your retirement income is large, the gap shrinks or vanishes. Large pensions, rental income, and required distributions from other accounts can push a retiree into a high bracket.

Fourth, you give up flexibility. Money locked until sixty five cannot pay for a house, a child's tuition, or a business idea. Before you defer, make sure you keep enough in plain cash to live on.

Fifth, leaving your job can trigger payout. Some plans pay in a lump sum when you separate. A big lump in one year can land in your highest bracket. Read what your plan says about leaving. Also note that certain "specified employees" of public companies must wait six months after leaving. That is a rule in Section 409A.

Questions to answer before you leave this page

Do you know the exact date your election is due, and have you marked it where you will see it? Have you asked your employer in writing which assets back the plan and whether they sit in a rabbi trust? Can you live comfortably on the pay you will still receive, with a cash cushion that does not depend on the deferred money? What payout schedule did you pick, and have you written down the dates and the reason for each? Do you know what happens to your balance if you leave, become disabled, or pass away? Have you looked at your company's financial health, as a creditor would, and are you at peace with that risk? Have you compared the tax you save now to the tax you may owe later, using your own figures? And have you spoken with a tax professional who has read your actual plan document?