Maximizing Your Deferred Compensation Plan: A Guide to Payout Options and Planning

Key Points

1. Understand Your Options: Deferred compensation plans offer various payout methods, each with pros and cons. Know the difference between lump sums, installments, annuities, and combination options.
2. Tax Strategy is Key: Careful tax planning is essential to minimize your tax burden. Consider the timing and distribution of your payouts to align with lower-income years.
3. Align with Your Needs: Choose a payout method that matches your retirement income needs and financial goals. Think about whether you need immediate access to funds or prefer steady, long-term income.
4. Consider Employer Stability: If you opt for installment or annuity payments, assess your employer's financial health to ensure the longevity of your payments.
5. Seek Professional Guidance: Financial advisors and tax professionals can help you model different payout scenarios and create a personalized strategy that's right for you.

Intro

Deferred compensation plans are a valuable, although sometimes risky, tool for securing your financial future. Depending on the plan and your age, they may offer various payout options to fit your retirement needs (or intentionally limit your options).

By understanding these options and planning strategically, you can significantly enhance your post-retirement income and minimize your tax liability. In this article, we'll explore different payout plans, provide practical tax planning tips, and illustrate these strategies with hypothetical examples.

Types of Payout Plans

1. Lump-Sum Distribution

• Description: Receive the entire balance in one single payment. Often, this is the only option if an employee leaves the company before a certain age; the company plan I was in had an age of 55. Making the payment all at once creates a painful tax situation, which helps to create golden handcuffs.  
• Pros: Immediate access to a large sum, maximum flexibility.
• Cons: Significant tax burden in the year of distribution, potential for higher tax brackets.

2. Periodic Payments

• Description: Schedule a payment to align with a particular financial goal, such as children's college, and then leave the remaining amount in the plan.
• Pros: Cash payments that align with financial needs.
• Con: A one-time distribution can trigger a significant tax burden in the year it's received, potentially pushing you into a higher tax bracket. Additionally, your employer's plan may have restrictions on when and how frequently you can request distributions, including a waiting period before you become eligible.

3. Installment Payments

• Description: Payments spread over a specified period, such as 5, 10, 15, or 20 years. Payments over an extended time period allow for better tax planning and a higher after-tax amount realized.
• Pros: Spreads tax liability and provides a predictable income stream.
• Cons: Less immediate flexibility, dependent on employer stability for future payments.

3. Annuity

• Description: Regular payments for life or a predetermined period. The cost should be compared to purchasing an annuity on the open market, but it could be very beneficial in avoiding the tax burden associated with a one-time payment.
• Pros: Guaranteed income, potential for lifetime payments.
• Cons: Reduced flexibility, possibly lower returns compared to other investments.

4. Combination

• Description: A mix of lump-sum and installment payments. If offered, combining multiple options may allow for the best tax optimization.
• Pros: Balances immediate fund access with long-term income.
• Cons: More complex planning is required; immediate needs must be balanced with long-term stability.

How to Maximize Your After-Tax Dollars

Strategic tax planning is key when it comes to maximizing the after-tax value of your deferred compensation. By carefully selecting your payout options and timing your distributions, you can significantly reduce your tax liability and increase your net retirement income. Here are some practical tips to help you get the most out of your deferred compensation plan:

Tax Planning

• Strategic Timing: Plan distributions to minimize tax impact, considering current and future tax brackets. Distribute during lower-income years to reduce tax rates.
• Distribution Spread: Avoid large tax liabilities by spreading distributions over multiple years.

Income Needs

• Assessment: Determine your retirement income requirements and how payouts fit into your overall strategy.
• Alignment: Ensure the payout method supports your cash flow needs and lifestyle goals.

Employer Stability

• Evaluation: Assess the financial health of your employer, especially for installment or annuity payouts.
• Risk Management: Ensure the plan includes protections in case of employer financial instability.

Investment Strategy

• Review: Examine how your deferred compensation is invested and the expected returns.
• Alignment: Match the payout strategy with your overall investment plan and risk tolerance.

Estate Planning

• Integration: Consider the impact of the payout method on your estate and beneficiaries.
• Coordination: Ensure payout choices align with your broader estate planning strategy.

Regulatory and Plan Rules

• Understanding: Familiarize yourself with your plan's specific rules and available options.
• Stay Informed: Keep up with regulatory changes that may affect your payout options and planning.

Real-Life Examples

It helps to better understand the concepts with some real-world examples. For all examples, we will assume they are married and use the tax brackets below:

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Tax Rate For Married Individuals Filing Joint Returns

10% $0 to $23,200

12% $23,200 to $94,300

22% $94,300 to $201,050

24% $201,050 to $383,900

32% $383,900 to $487,450

35% $487,450 to $731,200

37% $731,200 or more

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Assumptions

Sarah, a 55-year-old executive, plans to retire soon but is unsure when. Outside of her current income, her annual income from her job is $200,000, and she has income from other sources of $60,000. She has accumulated $500,000 in her deferred compensation plan and is debating what to do. She would also like to start building her dream home as soon as possible because it could take a couple of years to finish. She expects it will cost $500,000 to build. If she takes the entire distribution while working, the tax on the distribution will be $148,185.

Example 1: Sarah's Lump-Sum Strategy

The Dilemma

Sarah is torn. She'd love to have immediate access to the funds to start building her dream home. However, she's also aware of the potential tax consequences of taking such a large distribution in one year.

Strategic Timing

After consulting with a financial advisor, Sarah decides to delay her retirement by a year. Waiting would allow her to take the lump sum distribution in January of the following year when she would have no other income from her job.

The Tax Savings

Let's look at the numbers. If Sarah takes the distribution now, her total income would be $760,000, placing her in the highest tax bracket of 37%. By waiting until the following year, her taxable income would be reduced to just the $500,000 lump sum, potentially putting her in the 35% tax bracket (adding the $60,000 of other income).

The Outcome

By strategically timing her retirement and distribution, Sarah could potentially save over $18,000 in taxes on the distribution. She can then use those savings to further fund her retirement dreams, like building her dream home or investing for future financial security.

But there is so much more she could save.

Example 2: Sarah's Installment Approach

The Dilemma

Sarah still wants to build her dream home but is hesitant about the tax implications of a lump-sum distribution - even if she waits a year. She is open to continuing to work for the next five years while the home is being built and is willing to consider using deferred compensation installments to cover a construction loan.

Strategic Installments

After discussing her options with Purpose Built, Sarah decided on a 10-year installment plan for her deferred compensation, starting immediately. This would provide her with a steady income stream of $50,000 per year.

Building the Dream Home

To finance the construction, Sarah secures a 5% interest-only loan for the $500,000 cost of the home. The annual interest payment on this loan would be $25,000.

Tax Savings and Financial Impact:

• Years 1-5 (While Working): Sarah continues to work, earning her annual salary of $200,000 and $60,000 from other sources, totaling $260,000. With the additional $50,000 from her deferred compensation plan, her total income would be $310,000. This would likely place her in the 24% tax bracket. After taxes on the $50,000, she would have approximately $34,000 remaining. This comfortably covers the $25,000 annual interest payment on her home loan, leaving her with an extra $9,000 each year. The total tax paid during this period on the distributions would be $60,000 (24%).
• Years 6-10 (Retirement): Sarah retires and continues to receive $50,000 annually from her deferred compensation plan. Assuming her only income sources are the $50,000 and the $60,000 from other sources, this would likely place her in the 22% tax bracket. After taxes, she would have approximately $39,000 remaining, allowing her to comfortably continue covering the $25,000 interest payments until the house is paid off at the end of year 10. Total taxes during this period would be $37,850 (15.14) on the deferred compensation distributions.

Tax Savings Calculation

• Lump Sum Scenario: If Sarah had taken the entire $500,000 as a lump sum, combined with her regular income, she would have likely been in the 37% tax bracket, resulting in a tax liability on the distribution of $148,185.
• Installment Scenario: By spreading the payments over ten years, Sarah's total tax liability over the period is likely to be lower. Her tax liability over the ten years on the distribution is $97,850. By receiving her deferred compensation in installments, she saved $50,335 in taxes compared to taking a lump sum.
• The Outcome: By opting for the installment plan and starting it immediately, Sarah can directly offset the interest payments on her home loan. This approach not only helps her manage her cash flow effectively but also allows for significant tax savings compared to taking a lump sum distribution. Additionally, she maintains financial flexibility by continuing to work for five more years.

Optimizing Your Deferred Compensation: Strategies and Best Practices

Strategic planning is crucial to maximizing your deferred compensation after taxes. With the right approach, you can significantly reduce your tax burden and boost your retirement income. Here's how:

Tax Optimization

• Time it Right: Coordinate distributions to coincide with lower-income years, potentially lowering your tax bracket. This is referred to as "filling up the buckets."
• Spread it Out: Avoid large, one-time distributions that could push you into a higher tax bracket. Installments or periodic payments can help.

Income Alignment

• Know Your Needs: Accurately assess your retirement income needs. Your deferred compensation should complement, not replace, other income sources like Social Security or pensions.
• Choose Wisely: Select a payout method (lump sum, installments, annuity, or combination) that aligns with your cash flow needs and lifestyle goals.

Employer Considerations

• Financial Health: If you're relying on ongoing payments from your employer, assess their financial stability. If you choose an annuity option, many companies will outsource that to an annuity provider. Make sure you know who that is and assess their financial stability.
• Plan Protections: Understand how your deferred compensation plan is protected in case of company financial difficulty.

Investment and Beyond

• Review Investments: Evaluate how your deferred compensation is invested and the expected returns. Make sure your payout strategy complements your overall investment plan.
• Estate Planning: Integrate your deferred compensation payout with your broader estate planning to ensure it aligns with your wishes for beneficiaries. Know what happens to your remaining payments if something happens to you, and ensure the beneficiaries are updated.
• Stay Informed: Keep up with changes in tax laws and regulations that could impact your deferred compensation.

Taking Action

• Financial Modeling: Work with a financial advisor to model different payout scenarios to understand the potential tax and income outcomes.
• Professional Guidance: Seek advice from a financial planner or tax professional to create a personalized strategy. Know what you are getting with tax advice and the actual deliverables. Here is a helpful guide.
• Regular Review: Revisit your plan regularly to ensure it still aligns with your goals and financial situation.

At Purpose Built, we understand the complexities of deferred compensation plans. Let us help you navigate your options and develop a strategy that secures your financial future. Reach out to us today to set up an appointment and receive personalized advice and expert guidance.

Your financial well-being is too important to leave to chance. Choose wisely.

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Frequently Asked Questions (FAQ)

Q: When should I start planning my deferred compensation payout?

A: It's never too early! The sooner you start planning, the more time you have to optimize your strategy and potentially minimize your tax liability.

Q: Can I change my payout method after I've selected it?

A: It depends on your plan's specific rules. Some plans may allow changes, while others may have restrictions. It's crucial to review your plan documents or consult with your plan administrator.

Q: What happens to my deferred compensation if my employer goes bankrupt?

A: This depends on the specifics of your plan. Some plans have protections in place, such as insurance or trusts, while others may be at risk. Understanding the terms of your plan is crucial.

Q: How does deferred compensation impact my estate planning?

A: Your chosen payout method can significantly impact your estate and beneficiaries. It's essential to integrate your deferred compensation plan with your overall estate planning strategy.

Q: Do I need a financial advisor to help me with my deferred compensation?

A: While not mandatory, a financial advisor can be invaluable. They can help you understand the complexities of your plan, model different scenarios, and develop a tax-efficient strategy tailored to your individual needs.

About the Author

Sean Lovison, CPA, CFP®, is a flat fee-only financial planner based in Moorestown, New Jersey, serving clients virtually nationwide. After spending 14 years as a corporate chief financial officer (CFO), receiving and designing compensation plans, he decided to help others navigate their plans.

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