By Michael Donahoe, CFP®
If you are a high-income earner, such as a physician or other healthcare professional, you may be familiar with deferred compensation plans. This type of retirement plan, typically offered through an employer, is a popular option because it can save professionals a lot of money, not only into retirement but during the working years as well. When using a deferred compensation plan, the professional can defer a portion of their income to the plan where it can grow tax-free.
If you are a high-income earner, this may sound like a great option. Any opportunity to avoid taxing your income is good, right? Yes and no. While there are some great advantages of deferred compensation plans, there are also some drawbacks to consider. Let’s discuss the pros and cons of deferred compensation plans before deciding if this is the best option for you.
The Benefits of Deferred Compensation Plans
For highly paid professionals, deferred compensation plans can be a good way to save for retirement after maxing out contributions elsewhere because deferred compensation plans have no contribution limits. Consider these additional benefits:
Tax Mitigation Strategies
Do you live in a state with high-income tax but are considering retiring to a state with no income tax, like Florida? Deferred compensation plans help you save on your tax bill by allowing you to put more money into your plan and lower your tax bracket while you are working. Additionally, if you are planning on moving to another state without an income tax for retirement, this could also provide some tax savings.
Retirement Income Bridge
Deferred compensation plans can be used to generate income for a couple or individual as they begin retirement and want to maximize their Social Security income by delaying collecting it until age 70½. It can also be used to supplement income in retirement if the market has taken a hit and your portfolio has suffered.
Deferred Compensation Plan Drawbacks
While the pros of deferred compensation plans seem like incredibly useful tools for your wealth management strategy, there are some points to consider when using a deferred compensation plan.
Company Solvency Risks
This may be the largest risk you can face when using a deferred compensation plan. If a company declares bankruptcy, your deferred compensation plan could be completely or partially dissolved in the bankruptcy. This is because when you participate in a deferred compensation plan, you are considered to be a creditor of the company. Also keep in mind that if you choose a longer-term payout option, this increases the risk that the company may go bankrupt during this time. You should closely examine your company’s plan and consult a trusted financial advisor before participating.
Lump Sums Could Affect Your Taxes
Most plans do not allow you to access the money earlier than your retirement, however, if you change jobs, you may have to collect the money in one lump sum. Collecting one large lump sum could wreak havoc on your tax mitigation strategy for that tax year.
Lack of Diversification
Deferred compensation should always be coupled with other retirement strategies that don’t involve your company. This is because as an executive, you may have an inordinate amount invested in your employer’s stock. If the company suffers an economic blow, your employer’s stock could lose value and your deferred compensation plan could also be in jeopardy. This could be devastating to your retirement plan.
We’re Here for You
Understanding all the specifics of deferred compensation plans can be tricky, but you don’t have to navigate these financial decisions alone. At Harvest Asset Group, we partner with our clients to help solve their retirement planning challenges. We understand that your financial plan is long-term, and we are committed to working with you throughout your financial journey. Because of our extensive experience working with clients, we know what to look for and what types of strategies will help to protect your wealth management plan from any risks associated with a deferred compensation plan.
To learn more about our unique approach to financial planning and see if we would be a good fit to work together, contact us at (207) 775-1151 or firstname.lastname@example.org. You can also get access to our best financial insights and tips by signing up for our valued-packed newsletter.
Michael Donahoe is the founder and principal of Harvest Asset Group, LLC, an independent, fee-only financial planning and investment management advisory firm in Portland, Maine. Michael enjoyed a successful corporate career in marketing and sales before transitioning to the financial planning profession, founding his firm in 2012, where he now leads the client services team and serves as the firm’s chief compliance officer. Michael earned his MBA degree from George Washington University and completed his educational requirements to earn the CFP® mark of distinction at the University of California, Berkeley. He is a Fee-Only and NAPFA registered financial advisor, a designation that followed the completion of rigorous continuing education requirements. Michael has lived in the Portland area since relocating from San Francisco in 1995 to be closer to family. He is active in community affairs and spends his non-working time enjoying the natural beauty of Maine.