Every fall, a familiar deadline approaches for executives with access to a non-qualified deferred compensation plan. Unlike a 401(k), where contribution changes can be made almost any time, a deferred comp election made for the coming year is generally locked in once December 31 passes. Miss the window, and the decision waits another twelve months.
Many of the conversations we have about deferred comp focus on the easy part: how much to contribute. Fewer focus on the part that actually determines whether the plan works in your favor: how and when the money comes back to you.
It's Not a 401(k), & That Changes the Math
The first thing worth understanding is what you're actually agreeing to. A 401(k) is your money, held in your name. Deferred compensation is different. It's a general asset of the company you work for. If the company runs into serious financial trouble, you're a creditor, not an account holder. There's no early withdrawal option and no loan provision. Once you elect a distribution schedule, you're generally committed to it until the timeline you chose arrives.
That's not a reason to avoid deferred comp. For many executives, it's a highly effective tax-deferral tool available, but it does mean the decision deserves more scrutiny than it usually gets.
Cash Flow Comes Before the Tax Question
Before any conversation about how much to defer, we start with cash flow. Contributing an extra 10 or 20 percent of salary on top of existing 401(k) contributions, health insurance, and other payroll deductions is only a good idea if the household budget can actually absorb it. We also look at what else is available, such as a cash bonus or vested stock, that might reduce the pressure to draw down savings elsewhere.
Once that's settled, the real decision begins: how much is enough, and over what timeline should it come back to you?
The Mistake We See Most Often
Here's the part that gets overlooked. People often treat the decision to participate as the only decision that matters, and default their distribution election to a single lump sum, typically paid out the year they retire.
That default can be expensive. If a sizable balance pays out all at once, it does two things at the same time: it creates a large tax bill in a single year, and it eliminates any further tax-deferred growth on that money going forward. For a plan that's grown for a decade or more, that combination can meaningfully shrink what you actually keep.
A Real Example
We recently worked with a client, five years from retirement, who came to us with roughly $3 million already in a deferred comp plan and plans to keep contributing about $150,000 a year. Their existing election called for the entire balance to distribute in one lump sum the year they retired.
Running the numbers, that balance was on track to grow to somewhere around $5 million by retirement. The existing election would have triggered a tax bill on the full amount in a single year, cutting the after-tax value roughly in half before a dollar was spent.
We split the plan into two pieces. Roughly $1.8 million stayed on the original lump-sum schedule. The remaining $1.2 million moved to a five-year payout, beginning five years after retirement, the earliest a new election is allowed under the plan and IRS rules. Future contributions were redirected to be distributed over a five year schedule starting at separation of service.
The result: instead of one enormous tax event, the income now spreads across roughly a decade. A larger share of the balance keeps growing tax-deferred for longer, and no single year absorbs the full weight of the tax bill.
What This Means for You
If your deferred comp elections were set up years ago, or set up quickly during onboarding and never revisited, take a look at what they actually do to your tax picture the year you retire. The contribution decision gets most of the attention. The distribution decision is often just as important, and it's the one many executives never go back and check.
Elections for the coming plan year typically need to be finalized before December 31. If it's been a while since you looked at yours, now is the time; reach out at www.vanleeuwenco.com to schedule a complimentary consultation.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
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