The following is a chapter from Employee Benefits: How to Make the Most of Your Stock, Insurance, Retirement, and Executive Benefits by Josh Mungavin CFP®, CRC® and Edited by Chris Boren & Tristan Whittingham.

 

Highly Compensated Employees and Executive Benefits

 

Deferred Compensation Plans

Deferred compensation is a written agreement between an employer and employee in which the employee voluntarily agrees to have part of their pay withheld by the company, invested on their behalf, and then given to the employee at a predefined time in the future. This allows the employee to potentially defer paying taxes on money earned until the employee is in a more preferable tax environment. Employees must pay taxes on deferred compensation at the time they are eligible to receive it and not when they draw it out.

You generally want to think about a nonqualified deferred compensation plan contribution as an unsecured loan between you as the employee and the employer, in which you lend your employer the amount of money based on the agreement that your employer will pay you that amount of money plus any earnings subject to the investment or a fixed stated rate of return at a certain point in time. Some employers may be worthy of this loan, while other employers are unlikely to pay it back; you must consider this reliability before you elect to contribute to a nonqualified deferred compensation plan.

Strategies and Timing

Deferred compensation can be significantly beneficial, especially when used in tandem with other employee benefits such as RSUs. The employee can sell the vested RSUs they would have to pay ordinary income tax on in that year anyway and live off the proceeds while deferring their regular wages in a retirement account, deferred compensation account, or other tax-deferred savings account.

The employee can also defer ordinary compensation (potentially until after they have left the employer) so they receive ordinary income during a period in which they might not receive any income, thus lowering the amount they are being taxed on during their working years. Although this can be very beneficial, it is not without risk, specifically employer-specific risk. This risk is realized when the employee participating in a deferred compensation plan is working for a company that declares bankruptcy or goes out of business. In this scenario, the employee is standing in line with other creditors of the business to collect on any portion of the deferred compensation plan they can during the bankruptcy proceedings.

You may also think about participating in the deferred compensation plan if you are on the border of receiving a financial aid award for children going to college, which can lower your income in the eyes of financial aid offices. This allows your children to potentially receive some financial aid that they might not otherwise receive. Furthermore, if you are involved or potentially involved in litigation, it may be worthwhile to put some of your assets into a deferred compensation plan since lawyers may be more focused on assets available now rather than money that will be available at some point in the future.

Typically, an employee chooses how much they would like to defer; any payout terms, including amounts in a period; or triggering event. When opting for the deferred compensation plan with little flexibility to change these options in the future, it is important to not only think about your current tax, income, and expense situation but also plan for the future to make sure you’ve done your best so it is unlikely that you will need to make any changes to the plan later.

It is also important to remember that the money is at risk any time it is held in the plan so you do not defer compensation for too long; the longer the money sits in the plan, the riskier it becomes. The deferred compensation amount also becomes larger, and what is known about your company now and for the next year may certainly change 10, 15, or 20 years down the road.

It’s generally recommended to make the maximum contributions to a retirement plan before thinking about enrolling in a nonqualified deferred compensation plan. There is a tax benefit to contributing to your retirement plan and the potential to take loans out of the retirement plan along with a potential match from your employer and protection from your employer’s bankruptcy. You generally have the ability to choose how much to defer from your salary bonuses and other forms of compensation every year, so some changes can be made.

Plan Portfolio and Risk

You may be able to guide the investment broadly in the deferred compensation plan, but you will generally be unable to make precise investments, such as choosing individual stocks to invest in, during the time it is invested for your benefit. However, you may be allowed to direct what percentage of your money goes into specific allocations of funds, such as how much goes into U.S. stocks vs. international stocks or into stocks vs. bonds.

Rather than allowing employees to invest money in the deferred compensation plan, some companies may pay a fixed or variable amount of interest on that deferred money, which may be a benefit in and of itself if you don’t need to live off the income. You may end up getting a higher percentage guaranteed return from the deferred compensation plan than you would expect to receive from a portfolio based on your risk profile (keeping in mind that putting the money in a deferred compensation plan certainly overexposes you to a single company by essentially accepting an IOU from your employer).

Tax Implications

When looking at your tax situation, it’s important to not only consider federal taxes and Medicare but also whether you plan to move from a high-tax state to one with low or no state income taxes or vice versa. In other words, if you move from a state like California, which has high income taxes, to one like Texas, which has no income taxes, you may be better off receiving the income while you live in Texas than while you live in California even if your federal tax rate remains the same. Likewise, if you plan on moving from Texas to California, it may be worth thinking about not participating in the deferred compensation plan even if your federal tax bracket will be lower in California. The difference between the lack of state taxes in Texas compared to the state taxes that will be due in California may push you into a higher overall tax bracket, meaning that it is worthwhile to receive the money while you are in a higher federal tax bracket while working in Texas—plus, you have the added benefit of not having to deal with the company-specific risk.

It is not necessarily the case that your tax rate will decrease during retirement even if the tax law stays the same since you may have Social Security earnings, required minimum distributions, and pensions, which could take you into a similar or higher tax rate than what you had during your working years. In that case, it may not be worthwhile to participate in a deferred compensation plan, especially given the company-specific risk you would be taking with both the deferred compensation plan and your earning power as an employed worker if your employer goes out of business.

As always, tax laws can and will change, and we may see income taxes rise in the future. This means that, even if you personally earn less money since it slowly comes through the deferred compensation payout at a lower rate than what you earned during your working years, that money may still be taxable in a higher bracket because the tax brackets have changed. As such, it is important to at least be aware of the risks faced by deferring compensation.

Remember that you may be able to receive a higher rate of return on the money if you can invest it in any way you want compared to the rate of return your employer’s investment options will provide you. This is very clearly a case of not letting the “tax tail wag the dog” and deciding whether it is worth accepting a lower rate of return for a lower tax bill or worth paying the taxes immediately and receiving the higher rate of return on your investments without being overexposed to individual company risk. The plan’s investment options may be limited to insurance options and fixed percentage return, or it may have limited investment options with high expenses.

Keep in mind that you will have to pay Social Security and Medicare taxes on any amount you choose to defer in the year in which it is deferred. This may mean that if you defer the money and your employer declares bankruptcy, you may not receive the money that was deferred, and you may have paid Social Security and Medicare taxes on that money in the past.

Plan Payout

As with everything that has a value for which it is possible to name a beneficiary, it is wise to speak with your HR department about naming a beneficiary on any deferred compensation plans just in case something happens to you while you are participating. The purpose of naming a beneficiary in this context is so your money will go directly to your beneficiaries rather than through probate.

Keep in mind that some circumstances can force you to realize the entirety of your deferred compensation plan payout earlier than you intended, pushing you into a higher-than-normal tax bracket. Such circumstances include being terminated from employment, passing away, or your company being acquired. This may force you to realize the entirety of your deferred compensation while you are still work. Hence, it is important to understand all the risks you face along with any potential changes to your employer before opting for a deferred compensation plan, even if doing so can be very profitable under the right circumstances.

When enrolling in the plan, it’s important to consider the distribution schedule your employer allows. Do they require you to take the payment as a lump sum distribution so your income is much higher for a single year than it would normally be, pushing you into a very high tax bracket when you would ordinarily not be in that tax bracket, or can you take money added over several years? Are you allowed to take money out of the plans before retirement, or do you have to wait until retirement? All these details should be laid out in the plan document, which will list the payment schedule and the event that will trigger the payments, every time the amount is deferred. Possible triggering events are a fixed date, a separation from service, a change in ownership or control of the company, disability, death, or an unforeseen emergency. This means that, it can be very important to monitor the health of the company you’re employed by so you know what may happen to your deferred compensation plan and then plan accordingly. You may find yourself in a position where you know the company finds itself on weak financial straits (which is not a triggering event) so you know you will be likely to have to attempt to get your deferred compensation through your employer’s bankruptcy proceedings if you stay with the company. With this knowledge, you can strategically retire or separate from service so you may be able to remove the deferred compensation from the plan before your employer goes bankrupt and not lose all or significant portion of your money.

Keep in mind that a nonqualified deferred compensation plan may also impose conditions on receiving the money, such as a non-compete agreement after retirement, so any decisions to change employer after separation from service can cause a claw back of the money in the nonqualified deferred compensation plan. Depending on how the deferred compensation program is written, you may end up forfeiting all or part of your deferred compensation by leaving the company early, which means you leave a substantial amount of money on the table.

Unlike a 401(k), you cannot take a loan from a nonqualified deferred compensation plan, and the funds are not accessible before the designated distribution event. In some cases, you may be able to change the election for when you will receive the deferred compensation. However, these changes must generally be made at least 12 months before the date on which the original payment is scheduled to begin, the election must delay the payment for at least five years from the previously scheduled payment date, and the election will not be effective until at least 12 months after it is made. This means that if you previously decided to retire at age 60 and you receive your nonqualified deferred compensation but decide to continue working until age 65, you may be able to extend the length of your nonqualified deferred compensation payout by the age of 59, 12 months before you turn 60 and are previously scheduled to receive the payout. So, you receive the payout at age 65 when you now intend to retire.

Capital Accounts

Capital accounts are the initial and subsequent contributions by partners to a partnership in the form of cash, assets, or profits as well as losses earned by the business and allocated to partners. The amount of money you get from liquidating your capital account does not necessarily equate to the reported balance of the account (whether prior to the business’s liquidation or the partner’s departure from the firm). Capital contributions can be variably based off a set amount of partner contribution tiers determined by years of service, the level of compensation, or the amount of equity you have in the firm.

Potential Advantages

Capital accounts can be very beneficial for employers and partners. The employer gets to show an asset on the books as long as it is kept in the books and not directly spent or distributed to partners with ownership shares. The company does not need to go to a bank for a loan when they can rely on partners for a loan. In addition, partners will often not closely look at the books—or not be allowed to look deeply into the books—before deciding whether the company is creditworthy. That being said, the interest rate given by the employer can be very enticing, and if the employer is stable, it can be very profitable for the partners who contribute to a capital account.

Like many things, this can be used for good or evil. The employer can get a loan cheaper from its worker than a bank, and the partner is less likely to have the ability to put the employer’s financials through a thorough underwriting process. It can be a win–win or a very one-sided affair, so it’s important to know whether you’re putting skin in the game or getting skinned.

Potential Risks

When contributing to a capital account, it is important to realize that in essence, you are giving an unsecured loan to your employer or partnership; thus, you are subject to the risk associated with loaning your company money. This is often seen as ownership in a partnership, but in reality, a number of capital accounts arrangements are calculated by way of a formula rather than as a true ownership in the partnership. This means your capital contributions may have a fixed valuation when you want to withdraw from the capital account, and they may earn a fixed interest rate or none at all while the money is held in the capital account (rather than giving you participation in the upside of the business’s growth). It’s not uncommon for the employee to receive a rate of interest tied to the return of some benchmark.

Your capital could be used to fund the short-term needs of the company or to shore up unsustainable distribution levels for partners. This may make the proposition look appealing in the short term, but it can have long-term consequences, similar to a Ponzi scheme held up by bringing in new partners’ capital and the ongoing operating cash flow of the business. In such a case, the capital account slowly destroys the firm for the benefit of a few people, and it’s a matter of getting your money out before the ship sinks.

Another important question to ask is whether the capital money being contributed is being used to run the business so no debt is taken on or if it is being wasted on bad decisions, expansions by management, or equity partner distributions that are higher than they should be. In other words, having funds in capital accounts can spur management to need to deploy the funds in investments, which in turn creates additional risk rather than shoring up the balance sheet.

Remember that the firm can find itself at a point where the equity partners making the decisions have the choice whether to continue an unsustainable path or to correct the path the firm is on. Under some circumstances, it may be in the best interests of the equity partners to continue on the destructive path and then jumping with their client base and starting over at a new firm. This may be substantially more lucrative to them than correcting the problems at the existing firm, which in turn makes the equity partnership look less valuable. Similarly, some partners in leadership positions have income levels that are well above what their book of business would be worth if they were to relocate, which means they can’t replace their income if they leave for another firm. This means the, the leaders at the firm may decide to continue the status quo to serve their best interests rather than serving the interests of the firm, and even if they wanted to, they be unable to change the firm’s business model due to the fiscal or political environment. So, remember that while this may often be very beneficial, in some cases it is less risky and more profitable for a firm’s leadership to allow the firm to sink rather than save it. So, any capital accounts kept above the minimum account balance required by the firm should be well researched, thought out, and debated before any decision is made to contribute. It’s also important to note that the firm may have a model for calculating partners’ capital accounts upon departure, and the liquidation of a firm may not provide sufficient liquidity to pay out all partners’ capital accounts in full.

The economic environment is also an important factor to keep an eye on. Even a well-run firm can run into problems during a sharp downturn since the ability to get partner capital during a financial crisis can come when business is slow, banks aren’t lending to firms, and there is increased weakness in financials; this all happens at a time when the dollar opportunity cost is high for the partner who contributes and the employer that needs money to continue running the business. This can mean some partners become hesitant to throw good money after bad in a downturn so they decide to invest elsewhere, causing a larger-than-normal need for a business that was otherwise sustainable.

Key Considerations and Regulations

It is very important to know the terms that govern the return of your capital. It’s not uncommon for a firm to stretch out the period during which it will return capital to any departing partner. The firm may also have a period during which you will not be allowed a return of your capital if you take a job at a rival firm. You may also have a vesting period; during that time, if you leave or something happens to you, you may not get a return of capital even if you do not work for a competitor once you leave. It’s also important to know what happens to your capital account if you get let go.

Make sure you understand whether you have any equity interest in the firm as a partner or if you have explicitly waived your interest in the form of equity and agreed to essentially be a partner providing a cheap loan to the equity partners. In other words, is the value of becoming a partner worth the amount contributed since your money may be gone the moment it’s contributed?

When looking at the financials of a partnership, it’s important to consider that the liabilities encompass not only the direct liabilities we think of, like loans and capital contributions, but also things like leases on furnishings, equipment, and real property. All these can add up to a significant level of leverage across the firm. This means, a company with no debt may still have a substantial financial risk.

It’s also important to know whether buying into the partnership will reduce your take-home pay and, if so, to account for that reduction in any decision of whether to be a partner in a firm that requires capital calls.

You may also find that high-ranking partners have special agreements to raise their flexibility in terms of partner capital, such as the ability to draw on non-interest-bearing loans, credit distributions against future draws, or guaranteed minimum distribution amounts.

 

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