Use a Deferred Compensation Plan To Push Income to Future Years

If offered by your employer, a deferred compensation plan allows you to (quite literally) defer income to future year(s); ideally to years where your income tax rate will be lower.

Strategy Overview

If your total compensation (including stock compensation) puts you in a high tax bracket, one strategy to consider (if offered by your employer) is utilizing their deferred compensation plan. These plans allow you to specify a portion of your salary that will not be paid to you in given year(s). Instead it's paid into a deferred compensation plan at your employer (in your name), where it is invested (according to your specified desires), and then paid out in future year(s) that you specify (when presumably your marginal tax bracket will be lower).

Tax Details

Many employers offer a 401k retirement plan, which is a type of "qualified deferred compensation plan." Less commonly, some employers also offer a "non-qualified deferred compensation plan" (NQDC). 401k plans are covered in many other tax strategy pages (e.g. Manage Your Income Tax Bracket); this page/strategy is specifically in reference to NQDCs.

NQDC's are materially less common than 401k plans, and also a bit unique. Their non-qualified status allows them to generally be more flexible (no contribution limits; withdrawals in years prior to a qualified age); but they also have some material tradeoffs, most notably that there is a potential risk of the assets not being yours if your firm declares bankruptcy. To learn more about NQDCs, see this link

In regards to tax-strategy, NQDCs allow participating employees to voluntarily defer receiving a portion of their salary or bonus income in a given year --> and instead have it be paid it (plus investment earnings or loss on it) in future year(s). The deferred amounts are not included in the employee's taxable income for the year deferred; rather, similar to a 401k, taxation occurs in the future year(s) when the deferred compensation is paid out (taxed as ordinary income).

In most cases, the employee needs to pre-specify the future year(s) when they would like the payout(s) to occur. And the individual would intentionally select year(s) where they anticipate that their applicable income tax rate will be lower --> such as year(s) when they individual takes a sabbatical from work, or is in retirement.

Key Benefits

• Reduce current year taxable income (and income taxes). Deferred amounts are not taxed until received in future years.

• Opportunity to strategically select payout in future years when you may be in a lower tax bracket. This can help you optimize your tax liability. Additionally, other associated strategies (e.g. relocating to a lower tax state) may also be paired with an NQDC to amplify the tax benefits.

• Ability to invest/grow deferred amounts tax-deferred. Assets in an NQDC can be invested, allowing your investments to grow tax-deferred until the deferred compensation is paid out.

Key Considerations/Flags

• Your employer must offer an NQDC plan for you to utilize it. Generally NQDCs are only offered by large, profitable companies. In our experience its rare to see an NQDC plan offered by a firm that has existed less than a decade, is unprofitable, or is worth less than $10 billion.

• The promised payments may not occur if your employer becomes insolvent prior to paying you. This is a major risk of utilizing NQDCs, and you need to carefully consider the potential future business prospects and solvency of your employer before utilizing their NQDC plan.

• Need lower income years in the future for the deferred income taxation to provide benefit. If your tax bracket is still high, the benefit is minimized.

Strategy: When to Consider This and When to Avoid It

🟢 When to Consider This Strategy:

• If your marginal tax rate is high, and you anticipate lower tax rates in future years. Deferring taxes to shift income to years with a lower lower tax bracket can provide significant savings.

• If you strongly believe your employer will still be here in the year(s) you specify for your compensation to be paid out. NQDCs have bankruptcy risk attached to the firm. You should only utilize them if bankruptcy feels like a very remote concern to you.

• If you anticipate taking time off work (e.g. sabbatical) in the near future. NQDCs are most frequently utilized as an additional retirement savings vehicle. But they can also be utilized if you anticipate a reduction in your tax bracket in the next few years, such as a sabbatical.

🔴 When to Not Use This Strategy:

• If you have concerns about your employer's business prospects. If your employer declares bankruptcy, most of the promised benefits of an NQDC may be in jeopardy, and you may only get a portion of your deferred compensation paid out to you.

• If you need funds now. If you need funds for personal financial items now, deferring the payout to a future year is not appropriate.

🟡 Consider on a Case-By-Case Basis:

• You expect to remain in the same high income tax bracket even after retiring. Your deferred compensation should still be able to grow tax-deferred until the year of payout, providing benefits. But if your anticipated tax bracket would be the same in those future years, the benefit of utilizing an NQDC is reduced.

Example