Summer is over, kids are back in school, and we’re swiftly approaching that time of year when employees need to make their benefit elections for the upcoming calendar year. There are many decisions to make during the open enrollment time period but one decision that often doesn’t receive the proper amount of attention is contribution elections to “non-qualified deferred compensation plans.”
What is a non-qualified deferred compensation plan?
Non-qualified deferred compensation plans (often simply called “deferred comp plans”) are additional ways that certain employees can save for retirement above and beyond contributing to a 401k plan or an IRA. Because they are tax-deferred vehicles typically only offered to higher earning employees or executives, they are often quite restrictive. For instance, distributions from the plan typically must occur many years from the time of the contributions and may not be changed without significant penalties. In addition, if being used to defer a portion of an employee’s bonus, the election must often be made many months before the employee knows his/her bonus amount. As a result, it is very important that employees spend sufficient time considering the following factors:
Will you be contributing the maximum allowable amount to your 401k for the year? If not, you may want to reconsider because 401k assets are protected by the Employee Retirement and Income Securities Act (known as “ERISA”), whereas deferred comp plan assets are not.
What is the outlook for your employer? Assets contributed to a deferred comp plan are not protected from your employer’s creditors in the event of a bankruptcy so make certain that the chances of your firm filing for bankruptcy before you receive all of your distributions are extremely low.
How long do you expect to stay with your employer? Because any departure from the firm (voluntary or involuntary) triggers your TAXABLE termination distributions from the plan, you should take your future employment plans into consideration before making any contribution.
What might your tax situation be when you receive distributions from the plan? While impossible to know what the tax code will be in the future, if you think your marginal tax bracket will be lower once you retire and begin receiving distributions, then contributing to the plan could make sense for you.
What investment options does the plan offer? Ideally, you have access to investments similar to those offered in your company’s 401k plan. If your only option is your company’s stock, you may want to think twice about contributing, especially if you have significant exposure to that stock already through an employee stock purchase program, restricted stock and/or stock options. Remember, diversification of your investments is key in helping to reduce your overall portfolio’s risk.
What are your cash needs now and what do you anticipate them to be in the future? If you have large expenses on the near-term horizon, such as tuition costs, the purchase of a new car, or home renovations, you may wish to wait to make a contribution. But with any contribution you do make, you must elect how and when you would like it distributed to you in the future. But distribution elections are generally governed by your company so you should make sure you take the time to understand the rules of the plan. If your company’s plan offers in-service distributions and re-deferrals (ask your HR department), these provide the most flexibility to address potential unexpected cash needs that may arise prior to your termination distributions.
Given the complexity of the decisions you need to make regarding a potential non-qualified deferred compensation plan contribution, I recommend that you start thinking about the answers to these 6 questions well in advance of any election deadline. If you are overwhelmed just thinking about these complex factors, though, don’t worry - I can help you. Contact me today at (925) 954-4966 or valerie@vgfinancialconsulting.com.